It’s only a matter of time until this market breaks and volatility comes crashing back in. When that happens, all stocks will fall no matter what business they are in, but you can use the trade shared in this article today to hedge your portfolio and make a 9 to 1 return if the market sinks lower.
With the way things are going, it feels like we may never experience high levels of market volatility ever again. The stock market has been so quiet in 2017, investors can be forgiven for thinking the days of high volatility are long gone.
And you never know, with how pro-business the new administration is, we could potentially go the entire year without any real volatility hitting the markets.
However, while prolonged low volatility markets are normal, it’s definitely not the norm for volatility to disappear entirely. At some point or another, we’re going to see the markets erupt with uncertainty. Essentially, volatility can vanish for long periods but can return just as quickly.
More importantly, when volatile markets return, they can wreak havoc on even the most diversified of portfolios. In fact, standard diversification isn’t enough to protect against large increases in volatility. All stocks tend to correlate during a major selloff.
Even the so-called low volatility ETFs aren’t immune to this sort of downside correlation. Take a look at the two most popular low volatility ETFs below, iShares Edge MSCI Minimum Volatility USA ETF (NYSE: USMV) and Powershares S&P 500 Low Volatility ETF (NYSE: SPLV). Then take a look at the chart for the actual S&P 500 during the same period.
As you can see, there really isn’t very much difference between the S&P 500 and either of the low volatility alternatives. Another thing to consider, while the low volatility ETFs may not have as pronounced moves to the downside as the S&P 500, they also tend to underperform on the upside.
And let’s not forget, they probably won’t help much during extreme selloffs, like during the financial crisis in 2008-2009. (I’d show you the graphs for back then, but these ETFs didn’t exist.) The fact is, the low volatility ETFs are still made up of S&P 500 stocks, just weighted heavily towards the ones that are historically less volatile (like utilities). By the way, utilities also got crushed during the financial crisis…
So what can you do to protect against a rise in volatility?
Once again, let’s talk about the S&P 500 Volatility Index (CBOE: VIX). The “fear gauge” measures implied volatility in S&P 500 options, just another way of saying what the market expects volatility to be moving forward. The VIX is one of the most popular ways for investors to hedge against volatility/selloff risk.
The VIX itself doesn’t trade, but you can trade options or futures on the VIX. VIX options can be expensive, but there are simple ways to reduce your costs.
For example, take a look at this massive VIX trade which hit the tape last week:
VIX April 15-20 call spread 1×2 trades 71,800 by 143,600 for $0.11
First off, this is an April spread, so it has a bit over a month until expiration. It’s a call spread which means the trader is buying the 15 strike and selling the 20 strike to save money on the premium.
It’s a 1×2, which means the trader is selling twice the 20 calls for every 15 call purchased in order to further reduce costs.
The trader paid $0.11, meaning the breakeven point is only $15.11 in the VIX. Max profit is reached at $20, and upside risk is essentially unlimited (due to the double short 20 calls).
Now, I don’t recommend a 1×2 spread for most people because it’s too risky, but the 15-20 April call spread (1×1) is only trading for about $0.50. That’s still pretty cheap and will protect your portfolio in the event of your garden variety selloff.
With a breakeven of $15.50 and a max gain of $4.50 (spread width of $5 – $0.50 premium cost), you get a decent bang for your buck. For instance, a 20-lot of this spread would cost you $1,000 (20 x $0.50 x 100) but could payout $9,000 (20 x $4.50 x 100). That’s a 9 to 1 payout ratio if the market sells off sharply and the VIX returns to its long-term average of right around $20.
Keep in mind, this is a hedge trade, and I don’t recommend it for you unless you’re worried about a market selloff in the next month (unlikely). I mostly want to show you that there are plenty of inexpensive options available to protect against volatility. I definitely don’t recommend the low volatility ETFs, really under any circumstance.