Do you need to be hedged all the way to Zero?

by Wayne Ferbert on February 28th, 2014

Our Buy & Hedge approach has really always been built around strategies that protect your downside. Our most popular three strategies have locked in downside: collars, long calls, and bull put spreads. These are all ‘hedged all the way to zero’.
 
What does that mean? It means you have built a floor in to your portfolio where you would stop losing money if the market goes down – even if it goes all the way down to zero. The market is not likely to go to zero – but the point is your hedge is absolute at a level and all losses stop at that level.
 
But the real question is: do you need to be hedged all the way to Zero? In other words, if your protection kicks in at X% below the market and the market isn’t likely going to Zero, is there a way to make some money on the fact the market is not likely going to Zero?
 
Let’s discuss an example. Let’s say you are in the collar strategy on say the SPY – S&P 500 etf. You own a long put maybe 10% OTM and you are short a call about 10% out of the money. In this example, let’s say the 10% OTM put is the January 2015 $168 strike. So, if the market goes below $168 between now and Janaury 2015, your protection kicks in. You stop losing money at $168.
 
But how far down do you think the market will go? If you think that there is no way the market would go all the way to $150, then why not sell the $150 put for January 2015?
 
If you sold that $150 put, you are basically agreeing to experience the losses again starting at $150 price in the SPY. Your protection would start at $168 and would go all the way to $150. You would have protected $18 worth of the loss. Then the losses would start again at the $150 price.
 
If the market went to $125, you would lose from today’s value ($186) down to $168. Then you would save the value from $168 to $150. Then you would lose again from $150 to $125.
 
Would the $43 loss feel good? Of course not, but the market lost $61. At least you protected $18 worth of your portfolio. Now, as a disciplined Buy & Hedge investor, you would use that $18 in profit in the put spread to re-invest in the market at the new lower price of $125. Now you own more shares than you had prior to entering the SPY.
 
If the market recovers to the $186 level, you will own 10%+ more shares.
 
In selling this put, we recommend that you match the short put expiration month to the long put expiration month. And we recommend that you sell it deep OTM – maybe one standard deviation further from the long put level.
 
You have no buying power issue with selling this put – because you have the long put that has a higher strike price than the short put. You don’t need any cash in your account to sell this short put if you already own the long put.
 
So, you can generate this extra return by not being protected all the way to zero. This really can go a long way towards helping to pay for the cost of hedging. Today, the short put at $150 is trading at roughly 45% of the cost of the long put at $168 for the January expirations. That would help pay for 45% of the cost of the hedge at $168.
 
So ask yourself the question: does your risk tolerance reflect the need to be hedged all the way to Zero? Or should you collect a little income being protected only within a range? Its worth considering.
 


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