In the Goldilocks spring of 2007, by allocating 2.5% of one’s equity portfolio to December 2009 1000 strike puts on the S&P 500, a manager could have greatly reduced, if not eliminated the risk of the (then 4.5-year-old) bull market topping out over the next 30 months. The puts, even if not purchased at ideal prices, could very easily have appreciated by a factor of 10 as of today’s close, or even 20 if purchased on dips and sold last Friday.
At approximately $130 each, they could still easily appreciate by another two or three times by expiration if the bear market deepens.
It goes to show that it can pay to worry, even if you don’t have enough conviction to take decisive measures like liquidating a portfolio and going to cash (or short) while a bull market is still intact.
You can also insure against missing out on gains.
The same strategy can be applied on the long side. Suppose the Dow falls under 3500 by mid-2010 (actually, plan on it). Most people would by then have a perhaps unhealthy fear of stocks, just as they had an unhealthy attachment to them 18 months ago (and still do). The market could be approaching a turning point by then, but few will have the conviction to dive in with a significant portion of what is left of their capital.
In this case, our worrywart manager (who has since seen the light and bailed out of his stocks), if he gets another contrarian hunch, could risk just a few bucks for, say, December 2012 calls at 5000 on the Dow. Since he is still 97.5% in cash, if the market continues ever further into the abyss (distinctly possible this time), it is no big deal, but if stocks sport a classic recovery rally, the manager could get himself a very nice portfolio return.
The key to the lopsided risk-reward balance is to act contrary to popular sentiment when it has been running in one direction for several years. At such times, optionality on counter-trend moves is dirt cheap. I suspect that such an options strategy could generate very satisfactory long-term returns without ever risking more than three percent of principal.
You would not even have to own options all the time. You would just start buying puts after say, a three year and 40% gain in the S&P, and add to the position on rallies as the bull market matured, never allocating more than perhaps 1.5% of assets per year. Your sell trigger for the puts could be the moment the S&P records its first 20% decline.
Some inverse could of course be applied when the S&P is deep into a bear market. Bears often don’t last as long as bulls, so perhaps you would start to buy long-dated calls at the two-year mark or after a 30% decline.
That said, this particular bear is of the sort that hibernates for 300 years and couldn’t care less what all the other little bears have been doing while he was asleep. I am going to be very patient about waiting for him to exhaust himself, and may not to waste any ammo on him at all, but hunt the smaller game in Asia.