Instead of buying options on individual stocks or a broad market ETF, Larry McMillan suggests a newer, easier way to protect your portfolio against disaster.
Even short-term traders are interested in strategies to protect an overall portfolio. Maybe you’ve got a retirement account you want to protect or even an intermediate term portfolio you want to protect.
Our guest today is Larry McMillan to talk about that and some strategies you can use. So Larry, talk about how overall I can protect my portfolio.
There’s really two ways to do it. One is to buy puts—well let’s actually start with the simplest way. The simplest way is to go and buy a put on each stock that you own, on General Motors (GM), IBM (IBM), whatever.
That’s a lot of work, especially if your portfolio is diverse. Maybe you have a lot of stocks. You have to buy a lot of different options, keep track of when they’re expiring, roll them over, all that stuff. That’s more work than most people want to put into it.
So the more common way is what I call the macro approach, where you go and you buy an index option and just buy one, make one trade, buy 100 puts or whatever is required, and protect your whole portfolio.
Let’s discuss the macro approach. There’s really, once you’ve decided to do the macro approach, there’s two things you can do: You can either buy puts on let’s say the SPX or the QQQ or whatever simulates your portfolio best, so let’s say SPX.
So you buy some out-of-the-money puts on that…and I don’t want to go in the whole computation of how to decide how many to buy, but basically you have to adjust your portfolio for volatility. So let’s say you’ve got a pretty volatile portfolio. Let’s say you own maybe Goldman Sachs (GS) and Apple (AAPL) and Google (GOOG). That’s more volatility than SPX.
So rather than just take the value of your portfolio and divide it by the strike price of SPX that you’re going to buy, you have to maybe adjust it for volatility, so you might have to buy two times the value of your portfolio divided by the strike. But in any case, you’re buying SPX puts. That’s sort of the old fashioned way.
The new way is to buy VIX calls. This way you get a lot better protection, especially in a true disaster. Most people that buy protection, it’s sort of like your house—you don’t really want to collect on your fire insurance, but if you have to, it’s there for the real disaster.
That’s the way you should think of protection for your portfolio too. If the market goes down 10%, I’m really not that concerned. It’s a 10% drawdown and all of that, but I don’t really want to pay for the protection to protect that because that means I’ve spent a lot of money on protection and over time, that’s going to be a wasted expense.
But if I go way out of the money and protect for a disaster, then I don’t spend that much on an ongoing basis, but it’s there when I need it—like in 2008, let’s say—and the best disaster protection is VIX because VIX will explode to the upside far faster than SPX will drop.
So when we’re talking about portfolio protection, we’re really talking about not really protecting against a normal drawdown in the market, but a big disaster that would really take out a big chunk of your portfolio.
Yeah, exactly. Like in 2008, we dropped 40% in a month practically, and last year we dropped 20% in a month, those kind of things. So VIX will really explode to the upside.
I have a pretty simple rule of thumb for how many to buy. Again, you need to adjust your portfolio for volatility though, so let’s say your portfolio is again twice as volatile as SPX, and let’s say you own $100,000 worth of stocks. In this case, you need to buy $200,000 worth of protection because it’s twice as volatile.
What I recommend there is for every $100,000 of portfolio you have, you buy seven VIX calls. There’s some math behind that, but we’ll just simplify it to seven VIX calls, three strikes out of the money, and the strike price is 2.5 points, so let’s say VIX is 20. You’d buy the 27.5 strike and you buy seven calls for every $100,000 you want to protect.
And how far out should I go?
One month, because the VIX futures and the VIX options adhere to VIX, and VIX is a 30-day volatility estimate. So if you start going out further in time, you’ll get the situation where VIX will go up and your product will not because it’s not really VIX, it’s something else. So just buy them near term and keep rolling them over.
There’s an interesting corollary here. We’ve done the study: If you had done this when VIX options were first listed in 2006, you’d actually be ahead on your protection right now, which is almost unheard of, but you made so much money in 2008, you made a bunch of money in the flash crash, and you made money again last August, and those three profits are enough to offset all of the losses.
Now I don’t expect that to be the case forever—seriously, it’s insurance. They don’t pay you to take out insurance. But so far that’s the way it’s worked out, and obviously there have been periods, say during 2006 and 2007, when you weren’t using the insurance and you were losing a little bit each month.
But then when it kicked in, it really did kick in. So in my way of thinking, the modern way is to buy VIX calls. Then you really have disaster protection.
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