Summary
- When investors think of portfolio protection, they generally think of buying Put options which will go up in value as the security they bought the Put against, goes down.
- But if you get your timing wrong, your Put option can quickly erode and fall to zero depending on how far-out your expiration is and your strike-price.
- Another popular strategy for portfolio protection would be to short individual stocks or ETFs. But if you have a retirement account, that's not allowed.
- A fast-growing alternative is what are called inverse ETFs. You can go long an inverse fund that is -1X, -2X or even -3X the direction of its benchmark.
- A -3X inverse ETF, like the ProShares UltraPro Short S&P 500 (SPXU), is the closest-to a Put option and though it also can decay over-time, it won't go to zero.
* I should include the disclaimer that like in any security, you can lose any and all of your investment. In this comparison, it's the relative time it would take to lose all of your investment
Should you be using inverse ETFs for portfolio protection? That depends on where you think the markets are headed and if you need to hold onto positions that are highly appreciated and don't want to take gains or you have positions that you need to hold onto for income.
For my clients, income is critical so I generally don't want to be selling my high-yielding CEFs if I don't have to. As a result, I've always included a level of protection with inverse funds from ProShares and/or Direxion .
Both fund sponsors specialize in what are known as geared ETFs that are either inverse, offering -1X, -2X and even -3X the inverse direction of their benchmark index or sector, as well as leveraged +2X or even +3X their benchmark on the long side. +1X is essentially the benchmark itself, which is why you don't see those offered, whereas -1X is essentially short the benchmark.
Here, however, I'm focusing on the -2X and -3X inverse ETFs that can be used to hedge, i.e protect your portfolio from market declines. The -2X and especially the -3X are obviously more volatile than their correlated benchmark, so you don't need to buy as much of the security to get enhanced protection.
For example, a -2X inverse ETF, like the ProShares UltraShort S&P 500 ( SDS ) , $42.55 real time market price , -0.5%, can essentially provide $10,000 worth of portfolio protection for every $5,000 purchased whereas a -3X inverse ETF like the ProShares UltraPro S&P 500 ( SPXU ) , $14.88 real time market price , -0.7% , can provide roughly $15,000 worth of protection for every $5,000 purchased.
What this means is that for every -1% loss in the S&P 500 ( SPY ) , $399.03 real time market price, +0.3%, SDS will move up roughly +2% and SPXU will move up roughly +3% .
I say roughly because even though these securities have become extremely popular, trading millions of shares every day with penny spreads, they're prone to decay over time like options. That's because these funds use derivatives to achieve their 'geared' -2X, -3X, and even +2X and +3X. And derivatives, like options, have time premiums that decay over time.
In other words, you won't see that decay on a daily basis but it would occur over months and the higher use of derivatives, like in SPXU, the more the decay.
This is no different than what would happen to a Put option purchased on say, the S&P 500. If you bought a Put option with a three-month expiration and a strike price below the current price on the S&P 500 thinking that will provide you portfolio protection, that may not provide much protection at all if the S&P 500 doesn't go down.
That's because buyers of options (either Puts or Calls) take on the time premium risk that the underlying security, in this case the S&P 500, moves the way that you think it will. But if it doesn't, then that long Put or Call option can go to zero and provide no protection at all.
There's nothing worse than buying a Put option with a one-month expiration that's slightly Out-of-The-Money (OTM), i.e. with a strike price slightly lower than the current price, thinking you've got protection, only to see your timing off by a month and the underlying benchmark only starts to go down after the expiration of your Put. So not only do lose your entire investment in the Put, but you have no protection after the expiration.
This is why it is much more advantageous to be a seller (writer) of options than a buyer of options. Buyers of options take on the time premium risk whereas sellers let time work in their favor.
I like to compare this to a casino vs. the gambler at the table. The buyer of an option is the gambler at the table while the house (casino) is the seller of the option. And we know that over time, the house almost always wins.
I will go as far to say that I have never seen anyone consistently be right on buying long options and over time, the vast majority will lose. I know a lot of readers will say that they have made money on long Call or Put options, but the longer you play with them, the more you are the gambler at the table.
As a result, I currently have written options on the S&P 500, the Russell 2000 Small Cap Index ( IWM ) , $188.59 real time market price, +0.2% , and other indexes and sectors out 1-4 months to June of 2023.
I also have a much larger positions in SDS and SPXU currently and unlike Put options, if I'm wrong and the S&P 500 goes up or goes nowhere over the next 1-4 months, I won't lose all of my investment.
Yes, the hedges will go down if the S&P 500 goes up and yes, there will be some decay, especially in SPXU, if the S&P 500 just bounces around over the next 1-4 months but ultimately goes nowhere.
But you have to look at these inverse funds from ProShares and Direxion as insurance policies for your portfolio. And like an insurance policy, they may cost a bit to hold onto, but you'll definitely be glad you owned them in case there is an accident.
Conclusion
As in all investments, timing is everything and the time to buy inverse funds like SDS or SPXU is NOT when the markets are in freefall.
The time to be buying these funds is into market strength when you don't need them. Think of it as buying an umbrella in the summer when the prices are down. And do so gradually. Don't go all in at once.
BTW, if you think you have missed out on owning these funds after the 2022 bear market, I don't think so. The S&P 500 ( SPY ) , $399.03 real time market price, +0.3% is more than likely in a price range of $370 to $410 for the foreseeable future and if there is a risk, it's probably to the downside.
Finally, I specifically have not included any graphics for comparisons of inverse funds to options. This is more of an introduction to providing portfolio protection in case of a market correction or a return to a bear market, so if you have questions, ask away!
Note: Prices may have changed since I started writing this article at 4:30 AM PST on 2/28/2023
For further details see:
Equity ETFs: For Portfolio Protection, SPXU Is A Better Alternative Than Put Options