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A Simple Trade to Help You Sleep At Night

A Simple Trade to Help You Sleep At Night

Major stock market indexes are at record highs. In fact, traders seemed to be almost unconcerned about the Federal Reserve meeting that would take place on Wednesday. Stocks opened higher and Reuters reported that the Dow Jones Industrial Average hit a record intraday high of 21,354.56 shortly after the open.

New highs have a way of making investors nervous. Market crashes always seem to start from new highs. But, of course, crashes are the exception. More often than crashing, markets usually continue trending higher after reaching new highs.

Although the probability of a market crash or a bear market is low, it is normal to be concerned about the possibility. Right now, some investors have what appear to be valid concerns about valuation.

Investors without access to expensive data feeds, which includes most of us, can use exchange traded funds (ETFs) to track the valuation of broad stock market indexes. SPDR Dow Jones Industrial Average ETF (NYSE: DIA), for example, is an ETF that tracks the Dow Jones Industrial Average. Yahoo Finance offers a glance at the ETF’s, and the index’s, fundamentals on the ETF’s “holdings” page.

The figure below shows the valuation ratios as provided on that page.

 

The price to earnings (P/E) ratio for DIA is nearly 18. Value investors will generally want to see a P/E ratio of 15 or less. The price to book (P/B) ratio of 3.24 is also a little higher than value investors would want to see in a value stock. A more comfortable level for this indicator is below 2. A value investor would also rather see a price to sales (P/S) ratio below 1.5, well below DIA’s current reading which is above 2.

Generally, the risk of a market crash or a bear market are higher when valuations are higher. The current readings are a warning to prudent investors that down side risks in the current stock market are growing.

Despite High Valuations, Investors Are Complacent

In addition to measuring value in the market, we are able to use an index to gauge the general level of concern about the market. This can be done with the VIX Index.

This index is maintained by the Chicago Board Options Exchange (CBOE). The CBOE defines the VIX as “is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the VIX Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.”

VIX is generally regarded as the Fear Index. It gets this name from its behavior during market selloffs. Usually, when the stock market is selling off, investors become increasingly nervous as prices fall further and further. Some investors will act on their increased nervousness by buying put options.

As the demand for put options increases, the factors used to calculate the VIX index increase in value. This pushes the value of VIX up as the prices of major stock market averages fall. Analysts noted fear rises as the selloff continues and dubbed the VIX Index the “Fear Index” since high levels of VIX are associated with high levels of fear.

This relationship can be seen in the chart below. You can notice that VIX, shown at the bottom of the chart, reaches high levels as DIA, shown at the top of the chart, declines. VIX is at lower levels in the chart when DIA is moving higher.

Right now, VIX is low. So, to sum up where we are, risks are high based in valuation and investors are largely unconcerned based on the VIX Index. This sets up a potential trading strategy.

Benefit From Complacency and High Risk

When VIX is low, options are generally considered cheap. This is true because of the math. VIX is calculated with options prices. When those prices are low, VIX will be low. Many analysts say the low VIX reflects investor complacency, in other words investors have become too complacent about risk.

The combination of a high risk market and low volatility sets up an options trading strategy.

Put options increase in value when prices fall. That makes buying a put one of the best strategies to protect against large losses. While owning a put can be thought of as an insurance policy against a market crash, the low value of VIX means the insurance is available at a low cost.

So, the strategy is to buy a put which brings us to the next decision which involves which put to buy.

There are puts available on DIA, the ETF that tracks the Dow Jones Industrial Average. But, if the stock market does crash, or if prices decline slowly in a bear market, the Dow tends to lose more than some other ETFs. Usually small cap stocks are among the biggest losers in a market selloff.

iShares Russell 2000 (NYSE: IWM) is an ETF that tracks small cap stocks. According to iShares, the ETF creator, this fund has a beta of 1.65. Beta is a measure of how much an ETF is expected to move if the stock market falls 1%. DIA has a beta of 0.94. That means we should expect IWM to fall 175% as much as DIA. In the last bear market, IWM significantly underperformed DIA.

Buying a put on IWM should help us protect more of our portfolio against a bear market. Now, we must consider which IWM put to buy. First we will consider the expiration date.

As the chart of VIX shows, VIX is at an unusually low level. That means put options are also at an unusually low level. In this environment, it makes sense to buy an option with a significant amount of time to expiration. This gives us a maximum amount of insurance at a bargain price.

For IWM, there are options available every month through the end of the year.

IWM closed at $141.14 on Wednesday. We could try to protect against 100% but that is expensive. The October put with a $141 exercise price is trading at about $5.65. The October $134 put costs about $3.20. This option strike price offers protection when prices fall by more than 5% and provides a reasonable balance between risk and cost.

The December $134 put is trading at $4.40. The December is expensive but protects a portfolio for six months. The extra cost of $1.20 seems reasonable for an extra month of protection.

The Trade

Buying the December $134 put protects against a market crash until December 15, the day this option expires. If we get a 20% decline in the stock market, IWM would be expected to fall 35% since it moves 75% more than large cap indexes. That would push IWM down to about $91.

At $91, the $134 put would be worth at least $43, nearly ten times as much as it costs. Since each options contract covers 100 shares, this contract would have a value of at least $4,300. One of these puts could help protect a $20,000 portfolio against the risk of a market crash through the end of the year.

As a rough guide, buying one December 15 $134 put for the current market price of about $4.40 can protect a $20,000 portfolio. A $100,000 portfolio could put crash insurance in place with five contracts. This would cost roughly $2,200, or 2.2% of the portfolio.

Right now, the market is offering investors cheap insurance. Buying a put can protect against large losses at a small cost. Buying a put option can also be a strategy that delivers a gain if there is a market selloff at any time over the next six months.

 

 

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