The markets are up - a lot, in fact! So far, the S&P 500 is up nearly 15% in 2012, with most of the gains coming since June, but that doesn't tell the full story. Much like the previous couple of years, 2012 has seen a lot of market volatility. With the recent two-month rise that produced almost 10% worth of the year's gains, traders are thinking about the market correction that is sure to occur sometime in the near future. Whether the correction will be only a few percentage points or something much bigger, investors and traders want protection, but is now the time to hedge?
Puts or Short?
Investors can protect their profits in a variety of ways, but retail investors often hedge by short selling or buying put options. For those unfamiliar with the options market, shorting a market ETF such as the SPDR S&P 500 (SPY) offers broad market protection, but this may be difficult because of the 150% margin requirement.
A better way to protect against a market downturn is through the purchase of put options. Traders can purchase put options on the same SPDR S&P 500 (SPY) ETF without the hefty margin requirement. A put option, much like short selling, gains value when the underlying index loses value. The downside to a put option is that options decline in value over time, but since this will likely be a short- to medium-term position, purchasing a put option that doesn't expire for four to six months can help mitigate the time decay problem.
Purchasing an S&P 500 put option in a market that has seen a large increase in value may provide an attractive risk/reward profile, but how do you know when the option is fairly priced? Possibly the easiest way is to look at the CBOE Volatility Index, what traders call "the VIX." The VIX is a measure of how volatile the market may be over the near term. Options are priced largely with volatility in mind; the more volatile the market is expect to be, the more expensive options will be if you're a buyer.
On August 17, the VIX hit a low of 13.45 but has recently regained ground reaching as high as 17.98. Its 52 week high was in October of 2011, when it reached 45.45. This makes the expected level of near-term volatility low, making the purchase price of options relatively cheap.
When the market corrects, the VIX will rise, making the price of put options more expensive, and that could make the risk/reward of purchasing puts less attractive. Investors know hedging while the market is still healthy represents the best value.
But Is Now the Time?
If you listen to the financial media and read any number of newsletters, you've likely heard that September is historically a bad month for the stock market. According to MarketWatch, September has seen an average decline of 1.13% over the last 112 years, compared to other months that saw an average gain of 0.75%.
Investment professionals, including veteran hedge fund manager Dennis Gartman, are growing skeptical of the current market rally. Gartman noted in a CNBC interview that hedge funds and institutional traders had ramped up their commodities weightings and that's where he wanted to be as well. He may believe that the market is overextended but he's not willing to bet against it just yet. Gartman, like other professionals, know that charts and other indicators may signal an overbought market, but that doesn't mean a pullback is imminent. The decision of when to hedge shouldn't be a market timing decision but instead one based on the risk/reward of buying the protection.
The Bottom Line
As interest rates have fallen, Americans have refinanced their homes in record numbers because a lower interest rate represents a better value. While put options are cheap, protecting your portfolio represents the same kind of high-value purchase that won't be available once the market enters a correction phase. Although there are many ways to use options to protect your portfolio, buying individual put options is simple, relatively inexpensive and allows you to decrease the overall volatility of your portfolio.
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