Portfolio Update: Options & Volatility

I wrote in my letter to clients earlier this year that the only thing I’m certain about in the markets moving forward is that volatility will be higher than the past few years.  As we move further down the path of currency wars and central bank policy divergences, there are some large risks looming overhead that could potentially create a sharp drop in asset prices, as we’ve already seen in commodities over the last 9 months.  Since the largest exposure for most portfolios is stocks, a primary focus for me is managing the volatility (and minimizing the impact of drops) of the stock market.

Over the past few decades, the simplest way for an investor to balance the risk of equity exposure was to invest in government treasury bonds, as they tend to be inversely correlated to stocks, especially when stocks drop, meaning they go up when stocks go down.  This would ultimately reduce the total loss for the portfolio and offer the ability to rebalance by selling bonds at a gain and reinvesting the money in stocks that got knocked down.  This dynamic has certainly been skewed against the investor in recent years though, as the risk/reward ratio is somewhat “out of whack” with interest rates this low.

Because of this, my favorite means to “hedge” stock market risk is to use stock options.  Selling options is a great way to create additional portfolio income as well as reduce the downside risk of the underlying stock.  Buying put options is the purest way to directly protect against a drop in stocks, but you have to pay for the “insurance” and most times you end up losing the money – which is good for your portfolio because it means your investments didn’t lose value but can be costly if you’re continually buying insurance you never use.  I rarely buy options for this reason.

A much more cost-effective way to potentially hedge stock risk is to look for assets that might be negatively correlated to stocks, like treasury bonds have been historically, but currently offer better value than T-bonds.  One such investment that I recently started buying, and hope to pick up more if it drops further, is stock in CBOE Holdings (CBOE) which stands for Chicago Board Options Exchange.  This is the exchange where options contracts are traded (like how most stocks on traded on either the New York Stock Exchange or the Nasdaq Stock Exchange).

The business model is quite simple – the more people trade options, the more money CBOE makes.  Knowing that we’ve increased our use of options, I’m sure other investors are too.  They also have exclusive rights to options on the S&P 500 as well as options/futures on the E-mini Index futures and Volatility Index (the VIX), which they created some 20 years ago.  These are the products that larger institutional investors and hedge funds will use to manage risk, plus they have higher profit margins for CBOE.  Because of this, CBOE’s profits, and thus its stock price, are often tied to the level of volatility in the market, which fits perfectly with my thesis of higher volatility moving forward.  Being that the company benefits from higher volatility, this makes CBOE a diversifier to typical stock risk while maintaining exposure to stocks in general.

CBOE has done a great job over the last few years of introducing new products, including weekly options and mini options (1/10^th the size of traditional options for high-priced stocks) for stocks, as well as a volatility index for interest rates.  Lastly, they’re essentially the last private exchange remaining, making them a potential takeover target for any of the larger exchanges that may find their monopoly on VIX products appealing.

CBOE Holdings – 1 year

The stock was recently downgraded by two different analysts, providing us with an opportunity to buy after the drop.  I love the shortsightedness of Wall Street!  Their short-term view and love affair with short-term performance continually creates wonderful opportunities for long-term investors.  They’re often judged on 1 year marks so they focus on factors that may make the stock move this quarter or next.  The factors that drive long-term outperformance of stocks, however, are completely different than the trivial question of whether or not a company hit its numbers this quarter.  Quite frankly, I hope the analysts are right and CBOE moves lower over the coming months… because I’ll be waiting there to buy more!

Purchasing Put Options

I mentioned above that I don’t like to purchase options, and rarely do it, but I did on Friday.  I’m currently hedging 20% of our stock exposure with options through December.  I’ve actually developed a mathematical system that I follow to tell me when it’s a smart time to buy options (to remove the guess work).  It hasn’t triggered yet, but I purchased the protection anyway because volatility has dropped so much the past few weeks, making the options very cheap to buy.  I have an uneasy feeling right now that we could see another sharp drop like we did back in October so I felt it was just worth it to buy a little protection.

I’ve also sold a call spread over top through June and will be selling put options with an even lower strike price each month to collect premium to offset the cost of the options we purchased.  Ideally, it would be great to completely recollect the cost over the next few months to create “free” insurance.  Odds are that I won’t actually hold the options through December though.  If we see a sharp pullback, I’ll most likely sell the options at a profit and look to then invest the money in some stocks that got knocked down.

What I’m essentially doing is tightening our distribution of potential returns.  For example: for an investor with exposure to the S&P 500 that isn’t hedged, they’ll be fully up or down what the S&P returns – let’s say up 10% or down 10%.  I’m squeezing that range by giving up potential upside to reduce the downside risk, so we’re looking at potentially up only 6% or down only 6%.  The “down only 6%” is more important to me right now.  We’ve had a strong start to the year and now that the stock market is once again approaching the highs, I’m looking to preserve some of those gains instead of giving it back in the event that we do see a sharp pullback.

Please note – the numbers above are for illustrative purposes of the example.  It won’t actually work out to be down exactly 6% if the S&P 500 falls 10%.  I’m simply saying we should be down less than the market.

Have a great week and thanks for following!

-Nick