A Cheap Hedge for This Market

The S&P 500 is now 3.2% of its all-time high at 6,100 and is showing definientia signs of rolling over.

So financial advisors, pension fund managers, and cautious individuals have been ringing me up asking what is the best way to hedge the heady 23% gain in 2024.

You can forget about buying the Volatility Index (VIX), (VXX). The huge contango, the discount front month futures contracts have too far month ones, almost guarantees that your hedge will be enormously expensive and expire worthless before it has the chance to do any good.

No, there’s a much better way to do this.

Buy deep out-of-the-money, long-dated S&P 500 (SPY) put options. You want to go deep out-of-the-money so your insurance policy is cheap.

You also want to go long-dated, so time decay doesn’t kill you and your option position lives long enough to do some good. By long-dated, I’m thinking five months out, like the June 20, 2025 option expiration date.

All of this logic points to the (SPY) June 2025 $530 puts today priced at $8.00, which as of today are 10% out-of-the-money.

Here is the beauty of this position. A put option rises in value in falling markets. But so does option-implied volatility, creating a leveraged hockey stick effect on the value of your put position. And deep out-of-the-money options always see implied volatilities rise much faster than near-money ones.

You don’t need the market to drop the full 10% to make enough profit in this position to offset losses elsewhere in your portfolio.

A much more likely 5% market correction would cause the value of the June 2025 $530 puts to jump from $8.00 to $14.00, a gain of 75%, as long as that drop happens soon. However, add in an expected pop in implied options volatility and the profit could be as much as 100%.

So how many June 2025 $250 puts should you buy?

Let’s say you have a $100,000 portfolio. Only two put option contracts would provide enough coverage for your entire exposure ($100,000/100 shares per contract/$530 (SPY) strike price) = 1.88 contracts rounded up to two. Two contracts of the June 2025 $530 puts will cost you $1,600 (2 X 100 shares per contract X $8.00).

In other words, $1,600 buys you an insurance policy on $100,000 portfolio exposure for six months. Sounds like a deal to me.

There are endless variations of this strategy. For example, it is a good idea to long-date your longs and short-date your shorts to maximize accelerated time decay in your favor.

In such a scenario you would stay long the six-month put option described above, but sell short one-month options against it, but with a strike 15% out of the money instead of 10%. I could go on and on. That cuts the cost of this hedge by two-thirds.

There are a few qualifications with such a simple hedge. Let’s say that you read the Diary of a Mad Hedge Fund Trader and have a highly concentrated portfolio focused on technology and financial stocks.

In such case, the tracking error between the (SPY) and your portfolio will be large (after all, that is the point), and you may not get all the downside protection you want.

On the other hand, what if we really get the 10% correction? What if the black swans suddenly land in flocks? In that case, the value of your June 2025 $530 puts soar to at least $29, and more likely $32 when you add in the expected effects of rocketing implied volatilities. The value of your hedge rises to $3,200.

Yes, you don’t get complete 1:1 coverage. But it’s better than going into such a route naked, with no downside protection at all.

Let’s say you’re a cheapskate and you want your insurance policy for free. Yes, this can be done.

There is another hedging strategy that is far easier to execute. Just take a long cruise around the world. That way, corrections will come and go and you might not even know about it, unless your butler brings you an online copy of the Wall Street Journal every morning, as mine does.

This is the hedging strategy most of you have pursued for the past nine years and it has worked really well. At least you end up with a nice tan and some pleasant photos.

As for the June 2025 $530 puts, they’re most likely end up expiring worthless, but you’ll sleep better at night. Such is the price of peace.