Two days ago, I made a speculative purchase of puts on the SPY ETF in preparation for the Brexit vote. I thought that by laying out my thought process and structure, it might provide readers with a different conception of how to design event-specific hedges. I also think that Brexit has some longer-term implications to owners of capital, so have included a brief section on strategic issues as well.
Brexit Hedge Transaction Overview
The day before yesterday (June 22), I bought enough put options expiring on July 8, 2016 on the SPY ETF to cover my entire portfolio in terms of notional value; the reference price for the SPY was around 208.80 and the VIX was trading at around 18.00. The strike price on the put options were 10% out-of-the-money (188.00) and because of that the total cost was only around 12 basis points of my portfolio’s value.
My thinking about the expiration date was simple – I thought paying for a couple weeks of time value would give me a reasonable cushion in case there was a Brexit recount or delay or if market reaction to the vote took some time to ripple through the system.
Normally, I don’t like to buy options for such a short time horizon, but in this case, there was a well-defined event that I would have a clear outcome before option expiration. This really is a “single-use,” event-specific hedge rather than a strategic one. I discuss strategic issues more below.
Even though the notional value of the contracts was the same as my portfolio, in fact, I did not consider this fact until I sat down to write this summary. The sizing was instead based on my back-of-the-envelope calculation of what I would be able to purchase if the SPY hit that value 10% below my reference level. If the markets do fall down to my strike price, I should be able to generate enough profits to add a position of 5%-10% of my portfolio’s value. This might take the form of a new investment or of increasing the size or leverage of a present one; which route I choose would be totally dependent on the relationship of a company’s price to its value.
Many people misuse hedges as safety blankets, in my opinion. A hedge should have a specific purpose and that purpose is increasing available cash when risky assets are relatively cheap. This requires the hedger to do something psychologically painful – take profit on the hedge just when the market looks its worst and buy stocks with the proceeds.
Part of my calculation was pure stinginess. As I mention in my book and in our IOI 100-Series training classes, I have an extreme aversion to paying good money for an option’s “time value” and seek to minimize these expenditures as much as possible. If I can get 10 contracts for the price of five by shifting my strike away from the money a little bit, I’m happy to do that in a speculative case like this one, where I anticipate closing the position before expiration.
I chose 10% OTM put options (known in the institutional world as “90 puts” because their value is 90% of the spot price) for two reasons. First, the 10% band around the spot price represent the most actively traded contracts, so I thought that I wouldn’t have to worry about not being able to exit the transaction when I wanted to. Second, as bad of a sign that I think Brexit is in a political and trade context, I doubt it will have much immediate effect on the health of US companies. The US is a pretty insular market and my experience has been that it usually sloughs off political events overseas pretty quickly. As such, if the market were to fall 10% to my strike price, I would certainly want to have cash on hand to increase my position in my favorite companies (which would be only minimally impacted by the Brexit anyway).
The best time to take profit on an out-of-the-money option is when it becomes an at-the-money option. The time value of an option contract is maximized At-the-Money, so taking profits there maximizes the leverage of the option contract. Right now, it doesn’t look like the S&P will fall 10% today, so I will watch the price of the stocks on my watch list and if any fall to a reasonable price, I may take profit on part of the hedge to increase my position in those companies.
Again, the take-away here is that a hedge is only value additive to a portfolio if you take profits and use the proceeds in a sensible way.
The fact that the Brits left the European Union is disturbing to me to the extent that it reflects the political undercurrents flowing through the developed world now. The UK Independence Party’s Nigel Farage espouses the right-wing populism evident in many developed countries in Europe and which has gained a remarkable amount of traction in our own presidential election this year.
Right-wing populism is a useful card for the politically ambitious and has been used dexterously by members of the ruling class since at least the closing days of the Roman Republic. It also has severe repercussions in terms of cross-border trade – the defining feature of modern economic life.
According to various articles I have read regarding the legal process of exiting the EU, even after the UK referendum is finalized, there is an extended time period – at least two years – during which various exit conditions can be negotiated. This is plenty of time for businesses to adjust to the new reality and draw up plans for operating under new conditions. As such, the effect on the value of any company will, in my opinion and from a purely theoretical standpoint, be minimal.
However, if Brexit is a signal of a stronger trend toward closing borders and generally restricting the flow of goods and trade, the very underpinnings of all global multi-nationals’ business strategy is at risk. More than that, economic growth – tenuous at best throughout the world at present – will certainly suffer and more resources will be expended in unproductive pursuits (e.g., duplicating manufacturing facilities in multiple locales, adhering to multiple sets of bureaucratic regulations, etc.). Additional stress to local systems brought about by migration and the climate-related issues will likely increase societal costs and exacerbate the slow-down in growth.
None of these presumed effects are beneficial to the owners of businesses over the medium term. Because medium-term growth hinges upon the efficacy of present investments, assuming that present investments will be less effective (because they are spent at least in part on unproductive, duplicate efforts), we should begin to reconsider our assumptions for medium-term growth rates – one of the three key drivers of any company’s valuation.
If fair value estimates do come down as a result of this process, it would imply taking less leverage and reducing exposure to companies particularly dependent on smooth and efficient international trade. If nationalist fervor increased, spawning trade wars, border conflicts, and other political and economic strife, we would want to position ourselves with less exposure to risky assets overall.
If you are watching CNBC right now, there are likely plenty of pundits and experts suggesting that it is time to act in some way or another. Their advice to action is prompted by the fact that their compensation depends in part upon your acting in a certain way. During times of market shock, the best action you can take is that of thoughtful reflection.
Punching your trading screen’s Buy or Sell buttons, while perhaps psychologically soothing, is economically damaging. The British public has reacted to a long campaign that appealed to emotion and unreason by voting in a way that will ultimately prove to be in their worst interest. You owe it to yourself and your portfolio to vote more sensibly.