Time to Protect your Stock Market Gains?

/Time to Protect your Stock Market Gains?

Time to Protect your Stock Market Gains?

By | 2017-08-18T16:54:57+00:00 June 10th, 2014|Uncategorized|8 Comments

VIX is currently sitting at the lowest levels since all the way back to 2007, and market valuations are rich.

The chart below highlights VIX over the past 24 years.

bb2

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

We were all sitting around the office the other day thinking about how expensive markets are around the world. And because we all are value investors by nature, the thought of high valuations scares us. That said, we know the perils of following your “instinct” so we always defer to models, but given these high prices and the iron law of finance, whereby what goes up must come down, the thought experiment of pricing out market insurance was too exciting to pass up.

I had Tao fire up the Bloomberg and get the put prices for the Jan 17 2015 contracts.

How much does it cost to ensure a 20% maximum drawdown? 60bps! You can pay 1.18 (avg b/a) and buy puts at 157, which is roughly a 20% drop from the current price of ~196 on SPY.

1.18/196 works out to around 60bps.

b1

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

But just how likely is a 20%+ maximum drawdown?

Seems pretty cheap, right? But that depends on how likely such a 20% drawdown is. Certainly, we could look to history for clues about this.

First, a look at rolling 5-year maximum drawdowns (a five-year rolling window). Hitting a nasty drawdown every 5-10 years is almost inevitable.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Below we analyze the top 30 drawdowns from 1927 through 2013 for the S&P 500 total return index.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

So large drawdowns are certainly probable, but not hyper frequent. Of course, these results are unconditional and don’t take into account current valuations. Nonetheless, they serve as a nice benchmark which we can use to think through the potential value of buying insurance in the current market environment.

Notice the 10-year return (marked LTR)? Wow.

Conclusion

I’m relatively young with a long runway to compound out of a nasty max drawdown event, so I’m going to probably pass on insurance.  However, if you are retired, worried about current market valuations, and can’t stand the thought of losing more than 20% of your nest egg, you might want to think about buying insurance on the market while it is relatively cheap. As always, you should explore the idea with your own financial advisor and make sure the idea makes sense for your portfolio.


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About the Author:

Wes Gray
After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
  • hari

    i’m not sure your analysis is complete here. when you buy a reasonably long-dated, low delta put, you don’t need the underlier to shoot past the strike to make money. at least early on, you make more from a re-pricing of volatility, i.e. a change in market sentiment. so analysing scenarios where your option winds up in the money is not a requirement for making money on the hedge. btw, you have a great website, keep up the good work! hari

  • Hari,
    I agree that the analysis above is over simplified. We did that to get the major point across. There are a lot of details we left out that folks digging into the trade would want to analyze and understand. A repricing of volatility makes the trade potentially more interesting as a hedge–you get the downside protection, but may also get a spike in the option value if the market really blows up. Of course, vix could drift even lower and the market might move a lot higher…then you’d feel silly buying a put. It will be interesting to see what happens.

  • Sean

    I’m concerned about the thoroughness of you analysis. You don’t show drawdowns for 2010 or 2011 in your top 30 chart, but I remember large pullbacks and I was worried about a double dip recession. The reformed broker posted a chart showing 13.6 and 16.8 percent drawdowns, respectively. It appears that you are using month end data, does this really throw out significant pullbacks?

  • Sean, I agree. I added a new chart to convey similar notion and I’ll have my guys hack on the top drawdown chart image. Should have it fixed ASAP. It is usually an issue with the transition from the raw source code to making it “pretty” in a chart that we can put on the internet. I’m sure its an easy fix.

  • Hey Sean,

    Turns out that your comment generated some pretty interesting discussion around the office. Our drawdown table was actually correct if you calculate the drawdown as beginning only after it has recovered from a previous high water mark (this is standard after searching around on other platforms-see below).

    We ran the numbers through the Bloomberg as well as the R performanceanalytics package (ie. table.Drawdowns) and got the same results table that we originally posted.

    Interestingly, you highlighted periods in 2010 and 2011 where there are certainly large drawdowns, but because the time series had not recovered from the 2008-2009 drawdown, it was not included as a seperate drawdown episode. I do think it would be more thorough to include ALL drawdown episodes as long as they aren’t overlapping with other drawdown events. We’ve built a code to calculate this very thing and after we run it through some robustness tests, we’ll post the results.

  • post fixed, fyi.