Wall Street nerds: How much does it cost to hedge against a 20-percent drop in the stock market this week?

by philg

One of the doomsday scenarios promoted by my Facebook friends is that the election of OrangeHitler (a.k.a. Trump) will cause an economic collapse, a stock market collapse, and a U.S. currency collapse. If we ignore the most dire predictions of a worldwide economic collapse, but assume they’re right about dollar-denominated stuff, what’s the best way to hedge against this possibility?

Let’s assume that Trump being elected dictator causes a typical basket of U.S. assets (stocks, real estate, etc.) to fall by 20 percent and that the S&P 500 tracks this as well as anything.

Assume that a Millionaire for Hillary has $5 million in assets (the house in Cambridge, Brookline, or Berkeley; stock portfolio; dollar-denominated pension and Social Security entitlements). A 20-percent fall in the value of these assets needs to be counterbalanced by a $1 million profit.

What’s the most efficient way to buy protection? A betting site shows Donald Trump paying out at 5/2. So a bet that would pay $1 million would cost $400,000, right? That seems excessive.

What about an S&P put option priced at 15 percent below the current S&P value? The option expires after a week and we buy enough that a 20-percent drop in the index results in a $1 million profit. This is where I need help from readers! What is actually the most efficient way to do this and what is the current price?

[Note that I’m asking for “my friends”; I think the market will go up about 2-3 percent after the election, whoever wins, due to the removal of uncertainty. If Trump is elected, rich investors can celebrate having someone in the White House who advocates for lower tax rates (not that Congress needs to listen). If Clinton is elected and the slow-per-capita-growth-but-high-immigration expanding Welfare State is continued, rich investors will still do fine because the S&P 500 can grow based on (a) foreign countries getting richer per capita, and (b) the U.S. being stuffed with more consumers via immigration. One of the reasons that there is a Trump v. Clinton divide in this country is that people who work at Apple or own Apple shares can prosper even as the U.S. stagnates. 62 percent of Apple’s revenue is from outside the U.S. (fourth quarter results). A voter who is living paycheck-to-paycheck actually does need for America to become great again (in GDP growth) in order to be wealthier; a voter with substantial assets can buy growth from Singapore, India, China, Korea, Taiwan, et al., even without doing anything more exotic than buying the S&P 500. I don’t need insurance against future U.S. economic stagnation because I get it by owning Apple and Google stock (indirectly through a Vanguard fund) as well as by owning foreign stocks.]

13 thoughts on “Wall Street nerds: How much does it cost to hedge against a 20-percent drop in the stock market this week?”

  1. The current level of SPY — an ETF that tracks the S&P 500 — is $208.55. So, the strike price for an (approximately) 15% out of the money put option would be $177. The last trade price for these options was $0.10 per share (note that I’m writing this on Sunday, so the market is currently closed). So, if the market were to drop 20%, you would make $1016 per options contract (which is based on 100 shares) at a cost of $10 (100 x $0.10) per contract.

    So, to make a $1,000,000 profit, you would need approximately 1000 contracts at a cost of about $10,000.

  4. Buying ammo (not guns) is easy to do in all states and doesn’t make you automatically evil. And ammo (so far since 2008) has never gone down in value – it contains both a labor component and a basic commodities (the material used to make a bullet) component – so it should always track inflation. If Hillary wins, expect ammo to spike in price.

  5. paddy, unless Phil already has an FID or LTC, there’s no way he can buy ammo in MA before the election. The absolute fastest I’ve ever seen an LTC turned around was just under 3 weeks.

  6. For someone with a net worth of $5m (High Earner Not Rich Yet), a large chunk of that would be in Cambridge real estate, doesn’t make sense to hedge that with equities or any typical instruments in the capital markets. The rest maybe $1-$2M in stock/bond investments is most likely in very liquid instruments such as SPY/Vanguard/etc with a good chunk of that in tax free 401k plan. If you are worried about a 20% drop, why not just sell the whole portfolio and buy it back after election? You won’t incur a capital gain in 401k, your portfolio is not big enough to move the market, and transaction cost/spread of your holdings are likely to be minimal. Much cheaper than dealing with options and other “clever” hedges.

  7. The thousand-buck options for the win. If it pays off, you also win every cocktail party palaver for years. If it doesn’t, you don’t even have to tell the wife.

  9. The 180 strike (currently 15% out of the money) expiring on 11/11/16 is only $0.03 per share ($3.00 per contract today), so you can put on your hedge for just $3,000 now.

  10. “If Trump is elected, rich investors can celebrate having someone in the White House who advocates for lower tax rates”

    Comey’s latest announcement provided a quick test of this prediction. Reuters: Stocks surge as FBI decision lifts cloud over Clinton’s campaign.

    Global equity markets surged on Monday, as did the U.S. dollar, putting them on track for their biggest gains in weeks after the FBI stood by its view that no criminal charges were warranted against Hillary Clinton.

    The news lifted a cloud over the Democrat’s presidential campaign and gave it new momentum just two days before the U.S. election, and sent the benchmark S&P 500 index up more than 1 per cent. The index was on pace to snap a nine-day losing skid, its longest in more than 35 years, and to post its best daily performance in over four months.

    European stocks were up 1.4 per cent and many of the safe-haven assets that had performed so strongly last week when polls showed Republican candidate Donald Trump closing the gap reversed course as gold and bonds fell.

    … Investors had been unnerved in recent days by signs of a tightening presidential race, preferring what is seen as a known quantity in Ms. Clinton, over the political wild card, Mr. Trump.

    “It is certainly a relief rally for Hillary Clinton – investors worldwide were concerned about the uncertainty surrounding Trump,” said Jack Ablin, chief investment officer at BMO Private Bank in Chicago.

    … The CBOE Volatility index, dubbed Wall Street’s “fear gauge”, was down 14.6 per cent, on pace for its biggest one-day fall since Sept. 21.

    Joe Harris’s advice seems pretty good to me.

    So what’s going on? Why wouldn’t the prospect of unified Republican control of the White House and Congress be electrifying US markets, instead of scaring them? Won’t reducing taxes to Singaporean levels lead to amazing levels of economic growth? No. This is the “government as consumer” fallacy. Taxation and spending is basically a form of collective shopping. For some goods (food, clothing) it makes no sense to buy them collectively. For others (roads, insurance) it does make sense.

    Joseph Heath, Economics Without Illusions:

    One of the goods that can often be purchased most efficiently through taxes is insurance. Since the benefits of an insurance scheme come from the pooling of risks, the size of the gain is often proportional to the size of the pool. As a result, it is in our interest in many cases to purchase insurance using the mechanism of universal taxation and public provision. This is basically how the health care system in Canada works. I pay taxes, and what I get in return is a basic health-insurance policy, provided by the state. So if Canadians want to consume more health care or a new subway or better roads, what are their options? The situation is the same as with the condo residents who want a new sauna: If people want to buy more of this stuff (and are willing to buy less of something else), then they should vote to raise taxes and buy more of it. It doesn’t necessarily impose a drag on the economy to raise taxes in this way, any more than it imposes a drag on the economy when the residents of a condo association vote to increase their condo fees.

    One can see, then, the absurdity of the view that taxes are intrinsically bad, or that lower taxes are necessarily preferable to higher taxes. The absolute level of taxation is unimportant; what matters is how much individuals want to purchase through the public sector (the “club of everyone”), and how much value the government is able to deliver. This is why low-tax jurisdictions are not necessarily more “competitive” than high-tax jurisdictions (any more than low-fee condominiums are necessarily more attractive places to live than high-fee condominiums). Furthermore, the government does not “consume” the money collected in taxes–this is a fundamental fallacy; it is merely the vehicle through which we organize our spending. In this respect, taxation is basically a form of collective shopping. Needless to say, how much shopping we do collectively, and in what size of groups, is a matter of fundamental indifference from the standpoint of economic prosperity.

    Trump’s belief that high tariffs and import substitution (as practiced by India in the 1950s and 1960s) will lead to economic growth is based on an even more egregious fallacy.

  11. Okay, I just followed Joe Harris’s advice and bought 100 SPY put options, strike price $180, expiry 11/11, for $300. (We’re not as rich as the Millionaires for Hillary, so we don’t need as much insurance.)

  13. Jeff, thanks for that, I was not aware that MA was so strict in ammo purchases. Crazy to consider it is where “the shot heard round the world” occurred.

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