GLD - The Art Of Hedging For A Market Meltdown: 5 Strategies (Ranked)

2023-10-18 11:02:07 ET

Summary

• Financial markets are prone to turbulence and market meltdowns are a recurring part of investing.
• Prudent investors can prepare for market meltdowns by understanding strategies and positions that mitigate risk.
• In this article, I explore the art of positioning for a market meltdown, delving into a range of strategies and assets that historically have shown resilience during downturns.
• I discuss buying put options, leveraging short volatility strategies, investing in treasuries, buying exposure to energy ETFs, and gold.

Financial markets are never immune to turbulence, and history has shown that market meltdowns, though unpredictable, are a recurring part of the investment landscape. Whether triggered by economic downturns, geopolitical events, or unforeseen crises, market meltdowns can wreak havoc on portfolios and test even the most seasoned investors' nerves. While it's impossible to predict precisely when or how the next downturn will occur, prudent investors can prepare themselves by understanding the strategies and positions that can help mitigate risk and preserve capital during turbulent times. That said, there is a lot happening currently in the world, and the theme of hedging should be more relevant than ever.

In this article, we explore the art of positioning for a market meltdown. We'll delve into a range of strategies and assets that historically have shown resilience during downturns, helping investors not only weather the storm but also seize opportunities that arise amidst the chaos. From safe-haven assets to defensive stock picks, and risk management techniques, this guide aims to equip you with the knowledge and tools to navigate market meltdowns (although I am not saying one will happen). In the following, I discuss my top five favorite strategies that may help protect an investors' portfolio from a market meltdown. The strategies are ranked, meaning that the first strategy is the most valuable, in my opinion.

Long Puts On The S&P 500

The first hedging idea that I want to discuss is also the most obvious: Buying put options on the S&P 500 (SP500). For those who are not familiar with puts, and options, put options are financial contracts that give investors for a relatively small fee (premium) the right, but not the obligation, to sell a specific asset, such as a stock, at a predetermined price before or at a specified future date. This means that as the S&P 500 falls, the value of the long puts rises, effectively providing insurance against losses in the portfolio. Accordingly, these options contracts provide investors with the ability to profit from a decline in the S&P 500 index, giving investors exposure to a direct, inverse correlation to the performance of the broad market.

What is so great about options as a hedge, in my opinion, is that buying puts gives investors the opportunity to cap downside, as limited by the maximum loss equal to the options premia outlay. Moreover, puts also allow investors to achieve significant, and tailored, exposure to the market's downside with a relatively small upfront investment. This "implied leverage" can significantly enhance the effectiveness of the hedge, basically allowing investors to insure their portfolio for 180-240 days at a 2-5% implied interest on the portfolio (with costs dependent on implied volatility, interest rate, dividend payments, strike and time to expiration). By selecting different strike prices and expiration dates, long puts offer flexibility in designing a hedge that aligns with individual objectives and expectations regarding the market's performance. Scenarios can be simulated here -- on the IBKR Options Calculator .

Finally, options on major indices such as the S&P 500 are highly liquid and accessible through all major brokerage platforms.

Leveraging JEPI's Short Volatility Strategy

The price of an option depends on market volatility. Higher volatility raises the price. This is bad for the put options strategy discussed in the previous argument, as times of market uncertainty usually come with elevated implied volatility levels on options, thus making the Strategy somewhat expensive for investors. An opportunity to avoid paying high premia to hedge the portfolio, and actually take advantage of the high implied volatility during times of market stress relates to call overwrite strategies, such as pursued by the JPMorgan Equity Premium Income ETF (JEPI).

To give readers a better understanding of the JEPI strategy , I point out that JEPI generates income by leveraging a combination of options selling and investments in U.S. large-cap stocks. Its primary objective is to provide investors with a consistent monthly income flow derived from the premiums earned through option sales and dividends from the stock holdings. To achieve this, JEPI creates a well-diversified equity portfolio with a focus on minimizing volatility, mostly dividend stocks, and complements the equity holdings with short call options on the S&P 500.

By selling call options, JEPI agrees to sell its underlying assets at a predetermined strike price, if the options are exercised. In ideal cases, the call options sold may not be exercised by the buyers, allowing investors to retain ownership of the underlying assets, and continue to retain the benefit from any future appreciation in the asset's value. Now, while the call writing may also cap an investor's upside potential, it also establishes a level of protection though the options premium, which can be especially valuable during market meltdowns (and this article is all about downside), as the premium income from selling call options can provide a buffer against potential losses in the underlying assets.

Investing In Treasuries

Buying treasuries is another no-brainer when markets behave nervously. Historically, in times of market turmoil and uncertainty, U.S. Treasuries, particularly longer-term bonds, have emerged as a safe-haven asset and a classic and effective hedge against systematic risk. Again, the fundamental reason for the Treasuries' value as hedge is actually quite simple: When market conditions turn turbulent, investors often seek refuge in government-backed securities. And talking about government securities, debt of the U.S. government continues to be one of the most highly regarded investment options on strong creditworthiness, despite the most recent controversies relating to the Fitch downgrade . Also, investors should not forget that the Dollar remains the world's most-widely used, and accepted, currency.

The attractiveness of buying Treasuries is of course also dependent on the broader fundamental backdrop of fixed income securities. In that context, the value of U.S. government backed securities shines very bright. For reference, the 10-year treasury yield is currently quoted at a 4.6% yield, outshining even some of the most highly regarded dividend benchmarks. Moreover, it is important to recognize that there may be another argument supporting an investment in treasuries -- namely the Federal Reserve lowering interest rates. With an implied effective duration of approximately 8, for every 100 basis points that the Fed cuts, the 10-year Treasury is expected to appreciate by 8-10% in value. The interest rate duration sensitivity is even higher for longer dated securities, such as the iShares 20+ Year Treasury Bond ETF (TLT).

Buying Exposure To Energy ETFs

Depending on the nature of the downside risk, buying energy-focused equity securities may be a great way to hedge systemic beta. Specifically, I see energy securities very strong in context of geopolitical tensions (especially relating to the Middle East) and inflation. More specifically, the reason why I like energy in times of market uncertainty is relatively simple, and fourfold: First, many energy companies are known for their consistent income and dividend payments. This income not only shields investors during market turmoil but can also serve as a source for reinvestment in undervalued assets; Second, energy assets have generally a unique quality of acting as a hedge against inflation. While inflation erodes the purchasing power of money, energy companies often experience rising revenues and profits during inflationary periods due to increasing energy prices; Third, energy stocks display defensive characteristics, akin to those found in sectors like consumer staples or utilities. No matter the economic or political backdrop, energy remains an essential product with inelastic demand; Fourth, investors should consider that market meltdowns are often succeeded by recoveries. Energy ETFs can enable investors to position for the eventual rebound, as energy consumption typically resurges as the economy regains stability.

To be fair, the energy argument per se encompasses securities in both traditional fossil fuel industries, as well as renewable energy markets. Expanding on the dividend argument, however, for downside protection I would prefer the fossil fuel exposure. That said, I recommend the Energy Select Sector SPDR® Fund ETF (XLE).

Buying Exposure To Gold And Precious Metals

Lastly, as a final asset to hedge against a market meltdown, let us not forget the yellow metal, gold. In times of economic turmoil and market uncertainty, gold has a consistent, long-dating and strong track record of performing well. Historically, the value of gold has tended to rise when other assets, such as stocks or currencies, have faced value depreciation or instability. In fact, gold often exhibits an inverse relationship with stock markets, meaning when equities face steep declines, the demand for gold tends to surge as investors seek a safe-haven asset (like Treasuries).

Moreover, Gold is often considered an effective hedge against inflation (like energy discussed above), something that is well acknowledged globally. Historically, the value of gold has transcended geographic boundaries and currency fluctuations, offering a level of stability in the face of international economic challenges.

Now, while gold boasts numerous advantages as a hedge, it is essential to also understand that gold does not generate income, and its value can be influenced by various factors, including currency movements and market sentiment. As such, if you buy an ounce of gold, and store it in a safe for 10 years, after 10 years you still will have an ounce of gold. And the extent of which the gold investment appreciated in value depends entirely on market participant's willingness to buy the yellow metal. Thus, buying gold is my least favorite hedging instrument, although I may consider buying some gold-focused productive assets such as miners.

Investor Takeaway

Preparing for a market meltdown may be a prudent strategy in an ever-changing financial landscape. Now, while it's impossible to predict the exact timing or triggers for such events, having a well-considered plan in place can help investors weather (unforeseen) storms. The strategies discussed, from (1) utilizing options, (2) buying alternative investments like JEPI, (3) investing in Treasuries, and diversifying with assets like (4) energy and (5) gold, can all play a valid role in safeguarding your portfolio. Sophisticated readers, and long-term Cavenagh Research followers, may argue that my article is missing Credit Default Swaps (CDS). This is true. But while CDS can be a valid strategy for hedging against credit-related risks during a market meltdown, investors should also consider that they come with complexity, counterparty risk, and accessibility challenges. Accordingly, retail investors may find it more practical to explore the strategies mentioned in this article. That said, it's crucial to remember that risk management is not a one-size-fits-all approach, and the right strategy should align with your specific financial goals, risk tolerance, and investment horizon.

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