Shields up on the Starship Enterprise (via Laser Fire Creations).
Q4 2020 hedge fund letters, conferences and more
Correlations Converging To One
Looks like we spoke too soon when we wrote Bitcoin Bounces Back. As we type this early Friday morning, Bitcoin prices are tumbling back to Tuesday's lows. Bitcoin's not alone. Checking futures now, everything's in the red, including gold, stocks, and oil. We still think Anatoly Karlin's Bitcoin prediction is likely, and we still think it will reverberate in the stock market. But that's not important right now though. What's important is getting you some protection in case the current selloff gets worse.
Here's a quick-and-dirty (and relatively cheap) way to hedge your portfolio today.
Setting Initial Conditions
For the purposes of this example, we'll assume your portfolio is worth $500,000, and that it’s closely correlated with SPY. We'll also assume you have enough diversification within it to protect against stock-specific risk, and that you can tolerate a decline of up to 15%. If you have a smaller risk tolerance, you can use the same approach entering a smaller decline threshold, Similarly, if you have a larger or smaller portfolio, you can adjust Step 1 below accordingly. If you have gold, bonds, or other asset classes in your portfolio, we'll address that at the end.
Divide Your Portfolio's Dollar Value: Hedging Stock Market Risk
Step 1
Divide the dollar value of your portfolio by the current price of SPY. For this example, we'll use numbers as of Thursday's close, but obviously, you'll use current data when you do it. SPY closed at $382.37 on Thursday. Dividing $500,000 by 382.37, gets you 1,307 shares (rounded up).
Step 2
Scan for the optimal, or least expensive, puts to protect against a >15% decline in your number of shares of SPY at the options expiration you want. We've selected April 16th expiration below. It's far enough out to give you some breathing room, and it's not too expensive.
This and the next screen capture are via the Portfolio Armor iPhone app.
As you can see above, the number of options contracts the algorithm presented was 13. Since each options contract covers 100 shares, what our algorithm does when you enter a number containing an odd lot like 1,307 is this: it slightly over-hedges the round lots (the 1,300 shares, in this case), so that your entire position, including those extra 7 shares, is protected against the drawdown you specified.
Note the cost here: $3,978, or 0.8% of portfolio value. The app calculated that conservatively, using the ask price of the puts (in practice, you can often buy options at some price between the bid and ask prices).
Step 3
Round up the number of SPY shares to the nearest 100 and repeat step 2.
Note that, in this case, it was cheaper to hedge 1,307 shares using the first hedge, so you would go with that.
Hedging Other Asset Classes
In our simplified example above, your portfolio was 100% stocks that were highly correlated with SPY. Let's say your portfolio includes a broader range of asset classes: 40% diversified stocks, 20% tech stocks, 30% bonds, and 10% gold. You could use the same approach as above using QQQ as the ticker for the tech stocks, TLT or LQD for the bonds (depending if they're Treasuries or corporates), and GLD for gold. So, in that case, you'd divide the dollar amount of your tech stocks by the current price of QQQ, etc.
Good luck.
