This Could Be the Perfect Trade for a Crash
Once again, we find that major stock market indexes are at record highs and new highs have a way of making investors nervous. There’s good reason for that. Market crashes always seem to start from new highs.
Unfortunately, there is no way to know when a crash will occur. And, the probability of a market crash or a bear market is always low because markets exhibit a strong upward trend in the long run.
But, one clue to future returns is found in valuation. High valuations are often followed by lower than average stock market returns. This is not an indicator that can be used to time the marker with pinpoint accuracy. But, it can be used to gauge the level of long term risk.
To assess valuation, investors can use a variety of tools. One of those tools is shown below. It’s the price to earnings (P/E) ratio for the Russell 2000 Index. This is an index of small cap stocks and small caps tend to be the stocks most at risk of a crash.
In the chart, the green line shows the P/E ratio based on earnings forecasts while the orange line is the P/E ratio based on reported earnings over the past twelve months.
Generally, the risk of a market crash or a bear market are higher when valuations are higher. The current readings, which are near all time highs, 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, “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, risks are high based on 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 iShares Russell 2000 ETF (NYSE: IWM), an ETF that tracks small cap stocks.
Buying a put on IWM should help us protect at least some of our portfolio against a bear market. The risks are limited to the amount paid for the option. The profits could be significant if the price of the underlying stock or ETF drops by a large amount. This is summarized in the chart below.
Source: Options Industry Council
IWM was recently trading near $170. We could try to protect 100% of our portfolio but that is expensive.
There are options expiring in June 2019 available. The June 2019 put with a $170 exercise price is trading at about $8.50. June $160 put costs about $5. This option strike price offers protection when prices fall by more than 5% and provides a reasonable balance between risk and cost.
The Trade in IWM
Buying the June $160 put protects against a market crash until June 28, 2019, the day this option expires. If we see a 20% decline in the stock market, IWM would be expected to fall 35% since it moves much more than large cap indexes. That would push IWM down to about $110.
At $110, the $160 put would be worth at least $50, about ten times as much as it costs. Since each options contract covers 100 shares, this contract would have a value of at least $5,000. One of these puts could help protect a $25,000 portfolio against the risk of a market crash for about nine months.
A $100,000 portfolio could put crash insurance in place with four contracts. This would cost roughly $2,000, or 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.