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November 24, 2012

It is time to stop standing before the mighty fiscal cliff, trembling about the calamity that higher taxes and lower government spending would have on the U.S. economy and stock prices should politicians send us headlong into the abyss.

It is time, however, to take action and do something about the risk of the cliff, like protecting your stock portfolio against a big fall while still participating in a big rally like last Monday’s 200-point rise on the Dow. Sophisticated investors long ago hedged their portfolios against the cliff, and it is not too late for you.

With SPY at $138, buy the February 126 put for $1.30 and sell the February 145 call for $1.15. At the beginning of the year, SPY was around 126; 145 is slightly above SPY’s 200-day moving average, notes Belmont Capital’s Stephen Solaka. The market will move around by the time you can model your own collar, so adjust accordingly.

And because educated investors are indomitable investors, study collars. Make the Options Industry Council’s optionseducation.org a standard reference. The site is funded by exchanges, and while the material can be dense because exchange-compliance lawyers are often overzealous, the site lacks hype, and that makes the information worth its weight in gold.

Read OIC’s Options-Based Risk Management in a Multi-Asset World. The study shows that investors who bought SPY puts that expire in six months, and consecutively sold one-month calls, improved their investment performance and significantly reduced risk. How many strategies increase returns and reduce risk?

The study found that over a statistically significant 55-month period the SPY collar returned over 22%, while only owning SPY produced a loss of over 9%. During the worst of the financial crisis in 2009, SPY fell as much as 51%, but the collar never declined more than 11%. The message: It pays to think strategically about hedging—just like investing. Collars work best when markets decline because collars cap upside during rallies by virtue of the call sale.

YES, YOU CAN RIDE THE MARKET long and strong in anticipation of Washington dramatically averting the cliff just before it would otherwise suffer a Humpty Dumpty-like fall. But hedge if you are sitting on big stock gains, or getting back to where you were before the credit crisis. Think of hedging like term-life insurance: If something catastrophic happens, you’re covered. If nothing happens, you slept well.

The animating principle of hedging is to synthesize time, risk, and money. Most people never have enough time, or money. They typically come to that realization when they are dangerously low on one or the other, and risk is suddenly dangerously high.