Preparing for Crash, or Not

15-05-2017 04:17:40

These days, everyone seems to be predicting an imminent doom. All you hear is CAPE is the highest, VIX is the lowest, Market Cap to GDP is peaking, cycle is stretched, China/Fed tightening and on and on. For the Indian markets, the optimists still exceed the alarmists by numbers. Yet, in my opinion, for indian investors, despite all the structural tailwinds, being a little bit concerned about your long portfolio at this point is justified. 

We won’t pretend that we can foresee if a market crash is coming, or when its coming. No, honestly, we don’t know. A quick internet search will throw up plenty of forecasters' names, each with his/her favorite indicator. This post is not about that. Rather, we want to discuss a plan here to safeguard all the profits I assume you are sitting on, if a correction comes.

Ok, so let's get into the details . At a high level, there is a philosophical question - to hedge or not to hedge . As per Buffet et al - investors should ignore markets. As long they have bought solid businesses, the stocks will come through, there may be a massive draw down, but things will come back. So, don' worry about hedging etc, switch off your TV and go read a book.  While some may find value in this approach, I find it hard to live with. To me it seems like being awake going into a surgery. Going in you think, yeah am cool, am gonna withstand the pain, no anesthesia for me. But what if midway the pain becomes too much, taking you to a point where you either die or get a panic attack? Unless you have tested your pain threshold before and know can survive, this can be fatal. I would like to be be safe. Taking the car analogy, I prefer to have my seat belt on, if I know a nasty bump may be around the corner.

So, if you are like me, the next question then is - so how do we go about protecting our profits? Overall, I think the idea is simple - to reduce your (long) exposure to stocks if you think market may fall. Here are a number of ways to achieve this:

  1. Sell your stocks and go to cash
  2. Buy puts on index as insurance to the portfolio
  3. Sell something else which is correlated to your portfolio so that your “net” long exposure is reduced – one can sell index or other ETF futures, correlated stocks or call options on these.

Let’s discus the advantages and disadvantages of each quickly. 

1) Selling the stocks in the portfolio is a clean approach, however it can take time to sell your stocks depending on how liquid the stocks are and the size of your holding viz-a- viz liquidity scenario in the market. You may also want to buy them back once markets stabilize, which means paying brokerage twice - once for selling once for buying. Overall, this approach can take time and is typically more expensive (with brokerages etc). 

2) Buying puts on index is also a simple idea. Some calculations are needed to determine the correlation of the index with the overall portfolio, the no of puts to be sold and the strikes of the puts etc. You can buy near expiry puts or long dated puts, however, its gonna cost you money. And every month that the market doesn’t crash and the puts expire worthless, it will be painful to watch. Same thing can be done by buying puts on individual stocks (if they exist), but overall buying index puts may be simpler from a transaction execution point of view.

3) One can consider selling index futures. Same way, one needs to determine the correlation between index and the portfolio and sell futures. One fo the matrix to identify portfolio's sensitivity to the market is beta and "theoretically", if portfolio beta is zero, portfolio should not fall with the overall market. Also, shorting index futures is negative beta, so a portfolio's beta reduces when you sell futures. Thus, one can decide how many index future contracts to sell which will reduce the portfolio beta to a desired level. 

3 - 1 ) One can also sell index calls to achieve a reduction in portfolio beta. More calculations are needed here as call prices don't move in 1-1 mapping with the index (basically call delta). Selling out of money index calls allows you to earn premium while you wait for the crash so its a positive carry strategy ( unlike buying puts, which is negative carry)

I think 3 & 3-1 are both good strategies, however one needs to keep monitoring correlations as it may be possible that while the index moves up, the stocks in the portfolio fall. Then you get hit both ways.

Now that we have outlines  few strategies, let’s now try to answer the next question - what is the right time to hedge? We will tackle this important question in the next post.