A Looming Recession Highlights The Need For Risk Mitigation In Your Portfolio

Having been an investor for more than two decades, I’ve evolved through numerous philosophies and investment strategies over the years. In the early days when I didn’t have much to invest, nor know much about what I was investing in, I didn’t really consider the risks. There just wasn’t that much capital involved. As time went on and the amount of capital started growing, risk management become more prominent in my thought process – especially after the financial crisis that scarred so many investors.

While I’ve used options on and off for many years, I never could seem to find a strategy that made sense and fit my investment goals. I wasn’t really interested in using options for leverage, but always saw value in them as a hedge. Ultimately, I’ve found that using a particular combination of LEAPS options provides an excellent hedge for downside protection. LEAPS are Long-Term Equity Anticipation Options and have expirations as far out as two and a half years. When used with quality ETFs as an underlying, it can provide a diverse, broad-based equity portfolio with downside protection of over 25% while still retaining upside annualized returns north of 10%. That sounds like a really good value proposition.

A Risky Situation

When the Fed ramped up rates over the past year to combat inflation, many pondered which part of the economy was going to break first or whether would chairman Powell ride his unicorn in for a soft landing. The Federal Funds target rate range kept going up and up, from 0.25-0.50% to 5.00-5.25%, and may still keep going up though the growing consensus is that the end is near. The answer came in March. Several regional banks didn’t do a very good job hedging duration risk, or at all for that matter, in their bond portfolios. The value of the portfolios dropped significantly as rates rose. Mix in a high percentage of uninsured deposits and the ensuing bank run quickly led to insolvency.

The bank failures started with Silicon Valley Bank and were subsequently followed by Signature Bank and First Republic Bank. The contagion still spreads, with shares of other regionals like PacWest (PACW) and Western Alliance (WAC). The S&P Regional Banking ETF (NYSEARCA:KRE) is down 38% since market participants first caught wind of Silicon Valley Bank’s stinking bond portfolio back at the beginning of March.

The debacle in the regional banking sector is one example of how things can go from seemingly fine to a burning dumpster fire in just a few days. This should cause a pause in investors allow self-reflection and answer some questions.

Focus on Not Losing Money First

I’m not sure if it’s a golden rule to investing, but it’s a great first step. Try not to lose money. This aspect is often overlooked by novices and veterans alike, especially when times are good and everything you do seems to be working.

It is easy to ignore the worst-case scenario or try to convince yourself that you’ll be fine emotionally being down 30% a week after you opened a position…because you’re a long-term investor. The reality for most is that is when you are your own worst enemy and prone to making poorly timed knee-jerk reactions.

Not losing money could just be buying treasuries and those certainly look a lot better now than they have for a long time. That gets you into the 3.5-5% return range with virtually zero risk if you’re actually buying the bonds and holding to maturity and not buying an ETF for anything more than a year out. There are still some questions though. Do you invest on the short end of the curve while contemplating re-investment risk? Do you push it out and wonder if duration risk is going to crush you and leave your capital tied up for a decade or more? Not going to lie. In the absence of any better ideas, short-term treasuries look pretty attractive and the tiny amount of spare cash I have sits in BIL, my choice for 1-3 month T-Bills.

The treasury bond base case stands worlds apart from the ZIRP/NIRP fed regime that existed not long ago that coined the term TINA. It made life a lot easier for the truly risk-averse investor…at least for now. Everyone is uniquely positioned on the risk-reward spectrum and everyone knows the more risk the greater the potential reward.

Be Realistic About Risk-Reward

In targeting high single to low double-digit returns, my focus is on equity ETFs. This definitely turns the dial-up on risk over treasuries but is mitigated by using options, specifically LEAPS options and we’ll get to that later. Your basic vanilla S&P 500 ETF (SPY) has a 9.5% annualized total return over the last 15 years. Returns for other ETFs are given in the table below.

Click to enlarge

(all return data from Morningstar)

All but one of the ETFs ran at least high single-digit returns, with several firmly in double-digit territory. Past performance certainly doesn’t guarantee future prospects but you need to form a baseline for expectations somewhere. Of course, most of the period of returns shown was during an unprecedented easy monetary policy regime set by the Fed. Similar to filling foundation cracks in your home with money and calling it a day. Those days may be over and one could easily wipe a few percentage points of returns going forward. Double-digit returns may still be attainable but will carry a larger amount of risk. All the more reason to add an extra layer of protection, which again leads to using LEAPS options to hedge.

Hedging With Options

One of the biggest issues I have when using options to mitigate risk is paying for downside protection. This is most evident in the simplest case of a married put. For starters, you start with a loss. The underlying has to increase a certain amount just to cover the cost of the put before the position starts making any money. On the flip side, the downside protection is 100% minus the cost of the put. That sounds great at first, but the reality is you don’t need downside protection all the way down to zero on a diverse basket like the S&P 500 ETF (SPY). Ideally, you want to cover the first 10 or 20% loss and then start realizing losses after that. Not the other way around.

To make the married put less costly it can be turned into a bear put spread by selling a lower strike put option. The area between the long put and short put options is the protection zone and the cost of the hedge is lowered. You still start out with a loss but don’t have to overcome as much to start hitting the profit zone. Neither this nor the married put caps potential gains so the position can ride all the way to the moon and back. No doubt that opportunity cost is a real thing but let’s not get overly optimistic in our expectations either.

Taking the bear put spread a step further to get to where my strategy culminates, you sell a covered call to pay for it. This results in a zero-cost or small credit hedge. For example, KRE closed around $36 at the time this was written. First things first, you’ll need to own 100 shares of KRE. Second, preferably on the same order, you simultaneously sell a covered call and buy a bear put spread. In this case, you could maybe get away with a break-even trade by selecting a 44C strike call and a 36P/25P put spread.

I usually place my orders at the midpoint or slightly above and then work my way down until it gets filled. Most get filled slightly below the midpoint. The example order was entered after markets closed so the spreads are a lot wider than they should be. The covered call strike might be able to be moved up to $45, but sticking with $44 is good enough to illustrate.

The put spread position effectively hedges out the first ~30.5% of losses while capping potential returns at ~22.2%, or an annualized return of ~7.9% + dividends + potential gains from rolling options over the 2.5+ year period to expiration. The current dividend yield on KRE is 3.91%, which would push potential returns to double digits. Having 30% downside protection might be enough to sway more timid participants into sticking a foot or two in KRE’s rough waters. I’ll myself have two of these hedged positions on at the moment. Admittedly, they both blew through the downside protection and are realizing losses. Given enough spare cash and I’d probably open a third.

I target the longest-dated LEAPS option available because it allows for the furthest out-of-the-money call strike that can cover the cost of the required bear put spread. This gives a nice wide range to play in. The strike prices of the bear put spread are determined by looking at implied volatility.

The concept of implied volatility is critical in options and also provides valuable insight even if you don’t use options at all. Implied volatility, or IV for short, is essentially a market consensus for expected price movement within a certain period of time. The higher the IV the higher the expected price movement.

I take a cue from the IV of the at-the-money put LEAPS option to determine where the short put should be sold. I’m buying a $36 put option with an IV of ~43%. I’ll look for a put option strike 43% below the current price of KRE to sell. Rounding up, that’s the $25 strike put in the example.

A lot can happen in 2.5+ years. Prices go up, they go down, and they go nowhere. Opportunities exist to take advantage of price movement in the underlying to make small profits by rolling options. I initially had no set schedule as to when to roll options but eventually settled into once a month on the primary options expiration date. That’s the 3rd Friday of each month. It’s rather simple. As prices increase, the short put option is rolled up. As prices decrease, the covered call is rolled down. At the money put IV is used to monitor the preferred range that both puts and calls should be within.

So how much net premium can you expect to squeeze out from rolling a short put option up if your underlying keeps going up in price? You can use Delta as a guide. Option Delta gives you an idea of how much the price of an option will change in relation to a $1 change in the underlying price. So if Delta is 0.5 the price of the option will go up $0.50 when the underlying rises by $1. Since the short put option side of the LEAPS spread is usually pretty far out of the money, Delta tends to be low. In my experience, you can expect to get 10-15% of the difference in strikes rolling up the short put. That means if you roll a short put up to $50 from $45, you can expect to get a net gain of

($50 – $45) * 100 * .125 = $62.50.

It doesn’t seem like much but can easily add a few percent to your annualized return over time.

The Portfolio in Action

I’ve been running this strategy exclusively for almost 8 months in accounts where I can. So far, I’m up 9.5%. If I held the same ETFs without hedging I’d only be up 4.4%. Keeping gains while zeroing out losses explains much of the difference and premium credits account for the rest. The table below outlines my current ETF positions and corresponding LEAPS setups. Note that many of the short puts and calls have been rolled since these were originally opened.

The next table shows how much net premium has been collected through the initial LEAPS setup and subsequent rolls. It also shows dividends that have been received. The current maximum overall profit potential and corresponding annualized return potential are also shown. They include the difference between the covered call strike and the purchase price of the underlying shares, dividends paid, and net premium. They do not include expected dividends, only those that have been paid.

The next table shows how much spread protection is in place for each position along with how much buffer exists before losses start incurring on the initial investment principal. Spread protection is simply the difference between put spread strikes. The loss buffer includes downside protection offered by the put spread and any price appreciation seen since buying the ETF. If it’s less than the spread protection, that means that the put spread is currently hedging losses. If it is more than the spread protection, the put spread is not hedging anything at the moment. If it is negative, I’ve blown through my hedge and begun realizing losses. Upside gain shows the profit from price appreciation, net premium, and dividends received. Downside loss shows the amount of price depreciation below the short LEAPS put. The total profit/loss just adds the two prior columns. It was easier to deal with in Excel if I handled the upside and downside in separate columns. For annualizing the returns, I use the option expiration as the end date for the time period.

As can be seen, I have a mix of ETFs in the portfolio, some of which I’d probably never buy without having a ~30% hedge to the downside to start with. Que iShares Clean Energy (ICLN), GlobalX Lithium (LIT), and Invesco Solar (TAN). I have a higher weighting of SMH at almost 15% than I’d otherwise be comfortable with. That position is working out great so far though. There are ten or so losing positions that have all had their losses hedged out, with the exception of the KRE positions. When you account for net premiums and dividends collected, these positions have actually made money.

For KRE, it is a reminder that you can’t predict the future. You can have some pretty good idea of what may come but ultimately it’s a series of currently unknown future events that will guide markets. Having some downside protection in place, I can at least say I’m only down 5.5% instead of 36% on one and slightly up on the other.

Profits are coming from three separate categories, price appreciation, net premium, and dividends. The breakout is shown in the following table.

It’s important to remember that the positions in a portfolio hedged in this manner need to be viewed as held to maturity. Once you enter into a hedged position using LEAPS options, it will be difficult to exit before expiration without taking at least a small loss or giving up most of your gains. This strategy is geared toward long-term investing.

Takeaway

Trying to protect your investment principal is never a bad idea. No matter where you stand on the risk-reward spectrum, it’s good practice to constantly question whether there’s a better way to achieve your goals. For me, the LEAPS hedge provides return potential consistent with realistic expectations while providing a margin of safety at no real extra cost other than opportunity cost. And while it’s true that some years come with outsized market returns, being hedged with LEAPS can extend your position over two years or more. The longer the period, the more likely the average approaches the norm.

As things progress, I’ll be looking at best practices for trying to capitalize on positions that have risen through the covered call strike. I only have one of those so far, ITB, and don’t plan on taking any action until another LEAPS expiration becomes available. My line of thinking is to roll out of call option to a farther expiration while also buying a deep-in-the-money call option to effectively turn it into a call spread. This would free up my original 100 shares of ITB to place a brand new hedge on. I’m open to suggestions if anyone has other ideas.