Fragile stock markets – how to protect yourself against price drops

The equity markets are expensive, there is a threat of recession and many other dangers are lurking on the horizon – a rather tricky combination for equity markets. Nevertheless, the stock market correction, although theoretically overdue, has not yet occurred. To the contrary, the S&P 500 index has gained a whopping 17 percent (in USD) in the first six months – a magnificent return.

This share price performance exemplifies a recurring challenge for investors: how do you participate in the long-term performance of the equity markets, while at the same time protecting yourself against potentially high price losses?

Hedging costs at a 4-year low

One possibility is to systematically hedge the equity share with put options. The further the strike price of a put option is below the current index level, the cheaper it is, but the lower the equity index must also fall before the protective effect of the option comes into play. Rolling hedging strategies with a strike price at 90 percent of the index level have proven effective in practice. To reduce hedging costs, a premium can be earned opportunistically with the sale of call options. It is important to execute this hedging strategy systematically, i.e. on a permanent basis, to ensure the hedge is not missing at the wrong moment.

In the current market environment, the premiums for put options for hedging the equity share are very favourably priced due to the sharp fall in market volatility. The hedging premium for a portfolio with 100 percent US equities costs slightly more than two percent (as at 12 July 2023). This is the lowest value in four years, as can be seen from the chart below. Hedging here consists of a put option with a strike price at 90 percent of the index level and a one-year term.

Hedging premiums are as cheap as they were back in 2019

Time in the market, not market timing

Institutional investors try to solve this dilemma by basically remaining invested in the market, but allowing certain tactical deviations from their investment strategies. However, even this approach does not protect against large temporary price losses. At present, there are sufficient reasons for a defensive positioning, such as the current elevated valuations, negative leading economic indicators or the increased geopolitical uncertainties.

However, timing the market is a very difficult undertaking. That's because incorrect market timing often results in missing the best stock market days instead of avoiding the worst days. This can have a significant long-term adverse effect on investment performance, as shown in the following chart:

SPI performance vs. SPI performance without the 10 best days

It is therefore worthwhile to consider focusing on time in the market instead of market timing, as well as using hedging as protection against major losses. The latter means trusting the chosen investment strategy in combination with a systematic hedging strategy more than one's own ability to exit and re-enter the market at the right time.

Additional information on how assets can be protected against potential losses can be found in the video: