Protecting your portfolio for Doomsday

Should there be another liquidity event

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Warren Buffet, a frequent guest of this blog, in thoughts and quotes, said there are 2 rules in investing. The first one is to never lose money. The second one is to never forget the first one. With that thought in mind, I will share my strategy to not only survive, financially speaking, to another march 2020 event but thrive and hopefully be less stressed about your current portfolio.

The conclusion

I will be buying call options for the ETF, exchange-traded fund, TLT, which is an aggregate of US 20 treasury bonds. I will do this for 3 simple reasons.

1-Historically, this ETF is inversely correlated to the general market return

2-TLT has currently very low volatility which means that the underlying options are relatively inexpensive.

3- The leverage that you get from this instrument means that you can protect your portfolio without spending a fortune.

Context

In the last week, Lyn Alden, Steven Van Metre, Alistair Macleod, and countless other macro strategists have given interviews where they discuss the probability, quite high in their opinion, of a potential stock market crash. I loosely define a market crash as a correction of major stock market indices by at least 30% and most of the time by as much as 50% correction. For the ease of this discussion, imagine your current trading account, pension fund, Roth IRA, 401k, You Only Live Once (YOLO) portfolio slashed in half. Yikes..I have seen this happen last year, -60%+ last march, 2014-2015 because I had exposure to European stocks and 2009.. We always get back up but I would love to mentally save myself from the literal physical pain and mental temporary breakdown. Sounds good right.

In the last month, I kept thinking, I love my current strategy. One thesis, commodity bull market ahead, leveraged through silver and uranium miners. I don’t actually want to diversify and buy bonds with 40% on my portfolio just like a balanced portfolio strategy would because I want this 35k to get to 500k in 5 years and a 5%-7% yearly return will not get you there. So juicy returns and no risk. Not a small request right? Then, what needs to be true in order for this “dream” to be achievable.

Testing Scenarios

The first solution is diversification. I will not entertain it for the reasons mentioned above. I could leave some cash on the side. Sure, let’s imagine that instead of a 100% invested portfolio and one with 90% invested and 10%, I would still take a 50% haircut in the event of a crash on 90% of the portfolio. Not great. What about buying an inverse ETF that pays 2x the inverse of the market which means that if the market goes down 50% in a couple of days, I would be making roughly 100% on that part of the portfolio. Sounds better indeed but a major drawback is that these inverse ETF reset everyday meaning that every day that the market keeps going up until a potential crash, you would end up losing money and would need to time this buy and sell action to the T. Alright, imagine I spend 1000$ as insurance on that product, my max return in this example is 1000$ profit and I would still take a 50% loss on 35k. Jeez, this is not a simple one. Let us check options then. What about the VIX, index of the volatility instrument, traded as an etf. If the market crash, this again is inversely related to the broad Market. How about some call options. The Vix is currently trading a 20$ per “share”. In past crashes, it was routine to see that the Vix at 50$. Those calls are currently priced at 1.50$ for April. I would not go further out in time as the price is too high. 1000$ will buy you 7 contracts. I currently forecast that the max profit base on the historical volatility of these options and the price of 50$ to 5$ per share per contract. Roughly, your 1050$ could then become 3850$ which is heading in the right direction but still not the best.

Fast forward to the brainstorming session

I often go for a run to brainstorm ideas and listen to podcasts at the same time. there is something uniquely creative that happens during this process. Last Thursday evening, I thought I had achieved the best strategy. I first put a trailing stop loss on most of my stock meaning, if my stocks move more than 15% down, my portfolio gets liquidated. My thinking is simple when broad equity markets go down 15%, we usually do not stop there. I also bought options on the 3x inverse of the market. If the market goes down 50%, then I would make a 150% return. Because of the leverage of the options market, I figure that my 160$ calls would yield 5000$ in case the market crashes. Not bad right. But this situation kept haunting me. That would still leave us in a negative place if the market turns on us… But I finalized my thoughts and rationale over the weeks and I am happy to present to you, an actual strategy that still yields positive results in the event of a crash.

The double whammy on options

First, what is an option? An option is a right, not the obligation, to buy or sell an underlying security, at a predetermined time at a pre-determined price. Let us make this example more tangible. TLT, the exchange-traded fund of our long-term treasury bonds, is trading at 147$ a share. A call option would give the purchaser of the option the possibility to buy the stock. Imagine that I buy the June call 170$ strike, the price at which I can buy the underlying stock, I would need to pay right now 0.82$ per share. Since every contract is denominated in 100 share increments, I would pay 82$ per contract. Using the most widely used model, Black Scholes, we can see that 2 metrics influence the most the price of options. The underlying price of the stock and the volatility. The time left on the contract, the interest rate, and the dividends paid by the stock also affect the price of the options but given stable interest rates and very low dividends, we still focus our attention on price and volatility. I will define loosely, volatility as the amplitude or the extent to which a stock moved in the last year. If a stock has moved +-10% in the last year versus one that has moved +-100%, the volatility on the first stock is very low compared to the second one. It also gives clues to the probability of a stock moving towards our desired strike price. TLT has a 20% implied volatility. Implied volatility and historical volatility are not the same things but to make it easy, we will say they are one and the same. In the last year, TLT has moved between 139$ to 179$ and implied volatility has moved from 15 to 70 a share which makes the stock very predictable, in theory, to forecast its future price as you can see from the stock chart below. Let us layout the foundations of the possible returns for a simple call purchase.

If the volatility would remain the same and the stock price would increase toward the strike price to mimic the price action that we have seen last year, we would get the following return. The first image confirms that the theoretical price of the call option and the model value are fairly close. (0.76$ versus 0.82$)

Imagine that with 30 days left to expire, we would have moved from 147 to 170$. The option price would be roughly valued at 3.70$ for a 350% return and no change in implied volatility.

If on the other hand, it would not happen but just to show the power of volatility, let us use the same example but imagine the price stays at 147$ but only this time, Implied volatility moves from 20% to 50%. In this case, the option value is now 1.80$ and that would generate a 120% return. Now finally, let us look at what is the most probable should the market crash. The price and implied volatility would go up in tandem. In that case, where the price goes up to 170$ and has the same implied volatility of 70 as of last year, the option would now be priced at 13.52$ for a 1548% return. That’s the strategy!

To visualize the payoff and return in case of a crash, I created the below graph. The only scenario that yields a positive return in case the market crashes is if I would buy the TLT options. The TZA options get us to almost neutral which is commendable. I will, therefore, for the purpose of the blog, also buy the TZA options and report on their respective performance.

On a different note, I have been getting a lot of questions about the terms I use that might not be straight forward. I try as much as possible to explain or leave definitions to guide you through. If there you still have outstanding questions, leave them in the comments sections. I will be more than happy to explain further! Final point, I seriously think this thesis to protect my portfolio is worth sharing. The more people know about these strategies, the better informed we all are.

have a great week,

Max