Warren Buffett’s adage, “Be fearful when others are greedy and greedy when others are fearful,” may be particularly apt as we approach year-end.
Despite a global pandemic (as well as trade wars, rising interest rates and the reduction in stimulus from central banks), the current bull market has yet to come to an end. If we discount the very brief selloff into “bear market” territory in early 2020, this bull run is the longest in history. Nobody knows when it will end, but the run has led to sizeable gains for most investors. The culmination of these factors begs the question: when do those gains become enough to warrant protection?
An investor with a highly concentrated position that makes up a substantial portion of their wealth, a portfolio with more capital gains than they’d like to realize in one tax year or even an investor who is nervous about potential downside but not yet ready to sell could all consider hedging. While nobody wants to give up an opportunity for additional upside, there are ways to protect against a downturn without just selling out of their equity positions. To wit, one can consider the example of homeowner’s insurance.
Someone who owns a $500,000 home may spend about $2,000 per year to insure that asset. Investors can liken home insurance to a small, highly leveraged bet that the house burns down. Assuming no unfortunate events occur, and the house is in just as good of shape at year’s end, that $2,000 will have provided nothing to the homeowner except peace of mind. With home values appreciating at an average of about 3.8% per year, the house will likely have increased in value by around $19,000. While the $2,000 spent for insurance is a drag on the return the home is generating, the homeowner still has the upside from owning the asset and has limited their downside risk by buying the insurance.
Equity hedging differs from home insurance in the ability to hedge only a portion of a position, to hedge a specific range of exposure (rather than the exposure down to $0), and to fund or subsidize the cost of the hedge by selling away unlimited upside (an equity collar).
Simply selling covered calls on an equity position provides only a partial hedge but could provide a way to structure a liquidation schedule for a position while providing cash flow in the near term. With volatility holding at higher levels than it has been for the past few years, covered call premiums are generating worthwhile cash flows (especially when compared to fixed income yields). For an investor more concerned with protection than current cash flow, those premiums could fund, or at least subsidize, downside protection with puts. Selling covered calls does cap one’s upside potential on a position but considering how much the market has run the last few years, “only” having another 10% of upside potential shouldn’t be too daunting a thought.
Insurance can often feel like a sunk cost as it’s not often that a house burns to the ground. Nobody plans for lightning to hit their home or a tornado to put a tree trunk in the living room. Rarely do we see these events coming before they are already here, and the same can be said of a bear market. As such, investors should consider the following- would you be more disappointed about the prospect of “only” making another 10% from current levels or seeing the gains of the past decade cut in half?
While some investors have time to wait out a dip, those nearing retirement may want to consider realizing—or at least putting a floor under—their current gains, if for no other reason than to prepare for the inevitable.
Nick Griebenow, CFA, is a portfolio manager for Shelton Capital Management’s Option Overwrite Strategies. Prior to joining Shelton Capital, Nick was a senior derivatives trader for a large national brokerage firm.