HEdging a diversified portfolio

H

hotwired

Good Day!
I don't have alot of experience with options but I've bought a few. I am familiar with the basic concepts of hedging and this is the basis of my question: My goal is to use options to hedge my very well diversified portfolio. I have sort of an "ivy league type" mix of index funds, managed funds, MLPs, mREITS, BDCs, etc. that should be pretty well positioned for decent performance when "things" are doing well and "not suck as much" (haha) when things are going to hell in an handbasket.

That being said, I believe there are times when it's pretty easy to determine that the market is in its last 1-2 quintiles of valuation (i.e. over valued) and that well placed put options during these times are prudent. I don't think a person has to hedge "year round"...only when valuations are saying "be prepared." Am I off base here?

THAT being said, I don't want to complicate things too much .... Is there one (or2) options I can buy that will at least decently hedge a diversified portfolio of 40% stock, 40% bond and 20% commod, REIT, etc? It may sound like a silly question, because of correlation...but my reading tells me that most asset classes are much closer in correlation than they were 10-15 years ago..hence I'm GUESSING here that an SP500 put might be an effective hedge against an entire portfolio??

Thank you folks for any hints in the right direction.
 
The problem with hedging a long portfolio with options is that options expire. So you have to buy them and when they expire... you have to buy them again. This can add up.

If you are holding a long portfolio for dividends you would be better off buying an inverse ETF that will make the sum of your holding have a net delta of zero... or close to that.

http://www.tradermike.net/inverse-short-etfs-bearish-etf-funds/

e.g.

http://finance.yahoo.com/q/bc?t=5y&s=^GSPC&l=off&z=l&q=l&c=SH&ql=1

Options are, of course, cheaper but you can use the ultras and ultrapros to make your hedge cheaper.
 
Volatility in general is a poor equity hedge (var swaps have -70% correlation with equity on average I believe). In addition it's on average overpriced, so the cost far outweigh the diversification benefits. A "good" hedge has -100% correlation with the security/portfolio and zero cost...
 
Thanks so much for those links. I am familiar with that strategy, and have had good luck with UUP and DUG in the past (shorting the dollar and oil). I was leaning toward the options thinking that 'hey, if I know when the market it overheated historically, and only buy puts when it is, then that alone mitigates my risk of over spending on the options." But I see your point .. it might be a better option to simply sell a couple of positions and trade into a single inverse fund instead. What is your opinion on the "doubles inverses?" I've read that you have to be careful because of the dynamics of the "daily" nature of those beasts. (i.e. there have been times when the market has gone down over an extended period of time but because it went up and down alot in between, the double and triple inverses didn't fare much better.)

Thanks again.
 
Agree with oldn that the inverse ETFs would be better for someone not that familiar with options. The other "option" is just sell some calls on some of your "over priced" funds that offer options.

Remember a hedge is not supposed to be a winning trade....you hope you will lose on your hedge.... so I wouldn't be putting too much in my hedge.
 
Ah, yes, I'm glad you reminded me of the "winning trade" thought. In fact, in this case, it would "unfortunate" to have a winning trade! This was one of my thoughts on mitigating the whole thing. If I use options, (or even Inverse funds), I don't want to blindly own them year round. I want to use prudent but simple (i.e. not spending 20 hours a week) analysis to make an "educated but reasonably accurate guess" as to whether the market is entering one of the final two quintiles of upper valuation, then hedge accordingly.

I do like the idea of selling covered calls as well. The logic being, "yes, the risk is I don't get the upside, but my research tells me there's not much upside anyway because the market is entering high territory." This protects me on the downside by giving me some "free money" (sort of) but doesn't kill me on the upside too much because I can buy the stock or fund right back again...

This is one of the things that maybe I'm missing with selling covered calls...I hear about the risk of losing out if the position moves sharply higher, but I'm guessing the typical scenario is that the stock on which the call is written on is (for example) 10. It moves to 12, someone excercises teh call and takes your 12 stock. you buy it back at 13 maybe...that doesn't strke me as a HORRIBLE scenario. I am green however, and may be missing something!
 
I think options are the preferred way to go:

1) If you are wrong about the turn around, you lose money. But you lose less than an inverse and your losses are capped at the premium. In addition, your losses slow the further you move from your PUT strike. An inverse ETF continues to lose in lock step with your gains. Leveraged inverses are not good for longer term holds (and they spell this out in the prospectus right off the bat. They try to mirror the DAILY performance, and anything longer is pot luck depending on market conditions).

2) If you are correct about the turn around, the options start to profit and they accelerate the more the down turn continues.

3) Options expire, but you can get long term LEAPS with several years to expiration which can help offset you time decay. You indicate that you expect to have some idea of when you need them, so I'd assume you also have some idea when you can remove them (although that's more market timing than hedging). Anyway, there aren't any free hedges. Just like regular insurance, you don't get back you premiums, but you're paying for peace of mind and the ability to avoid catastrophic damage to your portfolio.

SPY would work for general market. You might want puts on a fairly decent volume ETF like IYR to hedge against real estate, etc. It's probably easier to find a liquid ETF with puts for whichever sector you wish to hedge than to find a non-leveraged ETF with decent volume.

Anyway, my $0.02.
 
Quote from hotwired:
.....My goal is to use options to hedge my very well diversified portfolio......
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You do not need options to hedge your portfolio. Just leave it the way it is.
 
oldnemesis...I'm a little slow in the morning so bear with me...are you hinting that perhaps the best "value" (i.e. cheapest insurance) might be calls on the 3x inverse?
 
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