Protecting Your Portfolio Against a Crash


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Brandon Wendell

25 Jul, 2018

in Equities

With the recent rise in volatility, there has been a lot of talk about a potential equity market crash.  Many investors are nervous about when, not if, this crash will occur and are looking for some protection for their stock portfolios. Closing out your stock positions is an option, but many stocks pay dividends that the investors do not want to relinquish even when facing the threat of, or, during a crash.  Another reason for holding on to a stock position is to avoid tax ramifications on profitable sales of securities.

The most common protection that traders/investors seek is to buy puts on stocks they are holding.  The value of the put will increase as the price of the underlying stock decreases thus covering the losses in the stock position.  This is easy but also very expensive as you will have to pay a premium for every put you buy for every stock that you insure.

Fortunately, there is a less expensive way to protect a portfolio. You can use the index futures contracts as a hedge for your stock holdings.  Selling a future is easy if you know how they work, and selling futures is also allowed in certain IRA accounts.

Before you go out and sell the ES (the S&P 500 E-Mini futures Contract), you need to know how many contracts are needed to hedge your account.  The ES is the equivalent of trading 500 shares of the SPY but at a fraction of the margin cost.  At the time of my writing this article, the SPY is trading at about $277 per share.  500 shares would cost $138,500.  Comparatively, the overnight margin requirement for the ES is only $6160.

You need to analyze your portfolio and determine the Beta Weighting.  Beta is a measure of volatility versus the S&P 500 Index.  The index has a Beta of one.  If your stock’s Beta is 1.5, then it is 50% more volatile than the index.  On average, (though not every day), when the index moves one percent your stock should move about one and a half percent in the same direction.

There are several easy steps to Beta Weight your portfolio:

First, you can multiply the amount you have invested in each stock by the Beta of that stock.  Let’s take the sample portfolio below.


Fig 1

When you total the portfolio, there is $49,055 invested.  Adding the result of the individual Betas multiplied by the individual investments we have $48,605.55.  Dividing that by the total amount invested gives us a Beta Weight of 0.99.  This portfolio has nearly the same volatility as the S&P 500, so when the market moves in a particular direction, this portfolio should move the same and in the same direction.

Using your analysis of the S&P Index, you could determine how much you expect the markets to fall to their demand.  When you figure out the expected return, you could sell futures contracts to cover your losses in your stocks.  In the sample portfolio, the 1300 shares have a 0.99 beta.  To cover the potential losses, the investor would sell two or three S&P 500 eMini contracts to be market neutral, (1300 shares x 0.99 = 1287 and each eMini = 500 SPY shares). Two may be sufficient and three would actually profit when the market drops.

Even mutual funds have a beta, so the same can be done for a portfolio or 401k that contains mutual funds.  This can usually be found on most financial websites.


Fig 2

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