In the first half of September, the market has returned with a downward trend. In times like this, investors want to know how to protect or hedge their portfolios against a substantial hit.
Reducing Volatility Of Returns
A hedging strategy typically involves adding several positions to a portfolio so that the volatility of returns is reduced. A wide variety of hedging instruments and approaches are available.
As part of this, market participants can include exchange-traded funds (ETFs) that can protect them or even profit them when markets fall. Today we'll focus on the index, which is up about 13% in the last 12 months.
Earlier in July, we showed how investors might consider buying the SPDR S&P 500 (NYSE 🙂 to participate in the index's upward movements. SPY, which is currently hovering at $ 340, is also up about 13% in the past year.
Below we will discuss two ETFs that may help calm investors who fear risks in broader markets will increase in the near term.
1. Boost BlackSwan Growth & Treasury Core ETF
Current price: $ 32
52 Week Range: $ 26.39 – $ 33.24
Dividend Yield: 0.36%
Expense Ratio: 0.49% per year, or $ 49 with an investment of $ 10,000
The BlackSwan ETF (NYSE 🙂 tracks the S-Network BlackSwan Core Total Return index.
SWAN offers unlimited exposure to the S&P 500 index while hedging to avoid significant losses. Currently, approximately 88% of the fund is invested in US Treasury bonds of various maturities. The rest of the holdings are in-the-money (ITM) SPY LEAP call options with two different expiration dates.
We discussed in the context of covered call ETFs. Now comes another dimension: LEAP options. LEAP stands for "Long-Term Equity Anticipation".
Investors who believe in the long-term growth potential of underlying assets, such as SPY, should consider using LEAP options, which are long-term, usually one to two years to maturity.
ITG means that the strike price of the option is already below the current market price. As a result, investors can achieve more "index-like" returns.
Because the exposure to equities results from holding options, the fund has limited downside risk, limited to the amount paid for the premiums on those options. For SWAN it is about 10% of the total invested capital. In other words, in the event of a "black swan" event that would cause the S&P 500 index to fall, only about 10% of the fund would be at risk.
The two sets of LEAP options in SWAN have different expiration dates and strike prices. They are:
Long December 2020 SPDR S&P call expires with 283 strike (5.77%)
Long SPDR S&P Call June 2021 ends with 265 strike (6.17%)
Each of these options is rebalanced once a year. SWAN is up more than 13.5% so far in the year.
This ETF does not provide protection for current positions in a portfolio. SWAN is thus more suitable for investors who want to buy SPY soon, but are currently concerned about downside risks. For example, they can buy the dips in SWAN to participate in a longer term upward move in SPY.
In addition, this strategy can be adopted quite easily by those who are experienced in options and want to start building positions. In that case, 70 delta LEAP call options may be appropriate. Those investors would participate in the benefit of the S&P 500 (but not 100%), while it would significantly mitigate their disadvantage.
2. ProShares Short S&P 500
Current price: $ 20.13
52 week range: $ 19.16- $ 33.19
Dividend Yield: 1.1%
Expense ratio: 0.89%
The second ETF comes from the world of exchange traded funds. We should emphasize that while inverse funds can be effective hedging tools, they are more suitable for short-term trading than for long-term investments. Therefore, traders should monitor the portfolios carefully and possibly rebalance positions to maintain the hedging.
The ProShares Short S & P500 (NYSE 🙂 aims for daily investment results that correspond to the inverse (-1x) of the daily performance of the S&P 500 index.
As a result of aggregating the daily returns, a longer holding period can easily result in returns that are significantly different from the target. Therefore, for holding periods longer than one trading day, SH does not necessarily have to reverse to the S&P 500.
To achieve the desired reverse effect on a daily basis, fund managers hold derivatives – usually futures and swap agreements. The result is that over longer periods of time lapse and the negative rebalancing effect come into play.
So far in the year, SH has fallen about 16%. On the other hand, the S&P 500 index climbed about 5%. Similarly, SH was down around 22.5% over the past 12 months, while the S&P 500 was up around 13%. The difference in (reverse) returns is a good reminder of the fund's daily hedging objective.
Bear funds can be valuable for short term goals, especially for experienced traders. Long-term investors may want to learn more about how inverse funds work before jumping the gun.
Bottom Line
Today we discussed two exchange traded funds that use derivative products including futures, options and swaps. Before investing, it is important to have a good understanding of exactly how these products work.
Those more experienced with options may also consider developing their hedging strategies using options on the SPDR S&P 500 ETF.
For example, investors who already own SPY may consider using an at-the-money (ATM) or somewhat ITM backed call strategy with a time horizon of about a month, such as an October 16 expiration date. Such a covered call position provides some downside protection and reduces portfolio volatility, allowing for participation in a possible upward move.
However, if SPY falls significantly over the course of the month, the covered call may not provide adequate downside protection. Investors should keep a close eye on their positions and take further action if necessary.
Another alternative could be to buy protective wells that offer downward protection from the chosen strike price to zero. It is important to monitor the effect of volatility levels on option prices. Normally, we avoid buying puts when the volatility is too high as they can be expensive during these periods.
The final strategy to consider: bearish vertical put spreads in SPY. Investors should state how much downside protection they want, which would affect the amount they pay. Put spreads can help to eliminate additional for the volatility component in the protection. However, such spreads don't provide as much protection as protective wells.
Any of these listed strategies can apply not only to SPY, but also other stocks and ETFs in a portfolio.