With markets looking lost this morning, it is time to reflect on proper risk management in your portfolio, and how you may want to proceed on that front.
Quick note- I am sharing some ideas here that should only be considered by people who actively manage their portfolio and have experience with options, hedging, and overall market conditions. If this is not you, please use this article for education purposes but don’t use these strategies until you are more experienced.
It’s quite obvious that the correct trading position in 2013 was to buy the Dow on December 31 with 100% of your money and let it ride. And there has been little reason to sell unless you keep super tight stops. However, many folks likely were a bit more diversified than that, regardless of whether they were investors or traders.
Investors likely had a diversified portfolio of funds or ETF’s that included an allocation to Europe, Asia, emerging markets, commodities and real estate. If that is you, you likely underperformed the Dow by a decent chunk as your global holdings and commodities would have dragged you down.
Traders, especially the large trend traders, would never have put more than 1-2% of their portfolio at risk in any one idea so they likely had not only their stock index systems going, but their currency, commodity and bond trades going. It’s likely many of them have a position in S&P futures, and likely many have shorted bonds. But I’m sure some of them got ground up in the currency markets and foreign indices as they bought and got stopped out a few times (especially in the currencies!).
So those investors and traders are already diversified -but for those who are concentrated and need to add some risk management, let’s explore how to diversify and mitigate some risk. Also we have to cover ideas for those that did sell out to cash significantly.
Low cost ways
The last thing you want to do in an up-trending market is to sell out everything on the first minor correction and go all bonds. You have to give this thing some room to run. Of course removing some risk as the risk-reward ratio weakens is not a terrible idea, but some people like to keep the trend going until it ends. Also, on the other hand, some people have sold out significantly, without a re-entry plan, and now fear they may miss large further gains. For those reasons, I’ll address getting exposure for both sides below.
Here are some ideas:
VIX – (disclosure: I have a small position in Vix related ETN) the vix is bouncing to flat around the 12 level. It’s found support around 12 since January. Scaling in some kind of Vix options position as the market proceeds may be a cheap way to insure a bit. The Vix really moves when things get ugly and since we are trying to protect against an ugly scenario (not the 2% drops) this could be a good use of insurance funds. I wouldn’t overdo it but scaling in could make sense.
Nasdaq Options – (no position) for some reason, I have always felt that these options were a good deal for the nervous. As I write this, I could buy a call at 74 or a put at 73 (market price at this moment is 73.71) on the QQQ ETF for ~$1.10 (July 2013 expiration). That’s basically a 1% move to in the money and another 1.5% to be profitable on the option. 2.5% seems like a lot but since we can expect a wild ride when the entire market reacts to Ben Bernanke’s voice, that is not in my mind a big move. It could be advantageous to buy a call or put on a day of an extreme move in the opposite direction (because it could lower your price and the market will likely snap the other way the next day). So in other words, buy the put if the market is up and the call on a down day.
IWM options – (no position) these are a bit more expensive than the QQQ options meaning it will take a slightly larger percentage move to be profitable in them. But this index can move and it could offer you upside or downsize exposure as needed for a decent price. Word of Caution – in this market, the IWM is very strong, so I personally would be careful using this as a hedge to the downside. The market masturbators, as I call them, really crank this index so for longs, it may be a better bet to hedge upside “risk” (i.e. you’re holding a lot of cash, want market exposure but want to limit your risk).
TBT – this ETF (which some of my clients own) goes up when bonds fall (and rates rise on bonds). It seems to have hit a floor around 57 and it may make sense to accumulate anytime you can get this in the low to mid 60s (which may not be long as it is threatening to break above 70 today and did temporarily). My thesis had been to increase client positions if the stock market corrected, as people would buy bonds for safety, knocking TBT down (temporarily in my thesis). I may not get that chance as this market is itching to move higher (i.e. those same market masturbators can’t wait to buy more!). However, for those of you with large bond fund holdings, you may need to protect yourself with something like this, if you choose not to sell your bonds.
A note on bonds – they may also be a nice contrarian play but I can’t seem to find a cheap way to play them. Options are expensive on the TLT. So for now, I don’t have a cheap bond long exposure idea.
Options on gold-related investments – (note I own a couple of gold stock options) gold is so out of favor that call options on quality gold mining stocks can be had for very cheap. It could be a cheap way to protect against market uncertainty as this sector may be bought (even for a short time) vigorously if the markets gyrated wildly enough. They are also out of favor enough to possibly attract traders looking to put their money somewhere that wasn’t so extended up. And gold positions are so volatile, you don’t need much to get a good bang for your money (also for you aggressive types don’t overdo it here!).
Emerging Markets – this would be a long hedge. to hedge the possibility that China offers a large stimulus program or Europe finally decides to go all out and print money like the Fed, emerging markets would be a big beneficiary (think raw materials in Brazil, and manufactured goods in Malaysia, China, Indonesia, Mexico). It costs 2.5% in option premium to go long the emerging markets ETF (EEM – no position).
There are many more ideas but to recap, here’s what you could do. In a $100,000 cash portfolio, you could expose yourself to various opportunities (risks) in various investment themes for around $100 per 4-7% exposure. In other words, $100 at this moment gets you a July call in EEM at $40 ($4,000 position or 4% of 100k portfolio). $110 gets you long or short the QQQ ETF (a $7,300 position or ~ 7% of a 100k portfolio).
Work these figures on your own but you can see how many a little bit of everything can give you a diversified portfolio whether you are starting from cash or have some existing core positions to hedge around. I use these strategies myself for peace of mind (hedging often causes losses, but if it keeps me in a position, it’s worth it – just me knowing how my mind works and how to respond). And even though these are short term options, they give you diversified exposure for under 2% of your account value (or much less).
This is especially useful if your analysis tells you that the market is near an inflection point and that it could move strongly either way in the near future. But I will caution you that until you get a system or sense for these things, the ideas I shared above could cost you a lot of money (especially if you try them every month with no eye toward the general market).
Disclosure – as I noted above, at the time of this writing (6/10/13) I or my clients own the following securities mentioned in this column – Vix-related ETN, TBT, Gold stock options; I may sell these or buy more at any time