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A few years ago, Nassim Taleb, the philosopher of black swans, was in Munich. He was on stage at a conference, reflecting on the credit crisis and talking about things like the fallibility of thought, and forecasts, and the risk of systematically selling out-of-the-money options.
Taleb, a derivatives trader, also told the story of a trader who had an $8 million house, paid for by selling options to investors who wanted to hedge their stock portfolios. And while he bought insurance for his nice house, he didn't properly hedge his positions, so the story didn't end well.
That trader was like people who "take the escalator to go to the StairMaster," Taleb said. They're not making the connection to their health risk. "Perhaps it's a matter of explaining...that just like you have insurance [on your home], you should spend money insuring your portfolio."
Taleb's words, spoken in 2009, should be heeded anew in 2011, with the arrival of the historically volatile months of September and October and a recently strong advance in the Standard & Poor's 500 Index.
The broad index gained 8.5% in the eight sessions leading up to Thursday's opening bell. But strong price moves without strong trading volume -- characteristic of this recent rally -- often prove problematic. One takeaway from Friday's surprisingly stagnant employment report is that economic data are now even more likely to roil the market than before. And there are plenty more reports, many of them perhaps just as weak, to be released before year end.
So it seems prudent to buy late-year calls on the CBOE Volatility Index, or VIX, knowing what typically happens in financial markets when the air chills and the leaves begin to change color.
September is the most volatile month of the trading year. Almost all epic market corrections have happened in the September-October span, which is to investors what April was to the poet T.S. Eliot: the cruelest month, or in this case, the cruelest pair of months.
Eliot worked as a banker, so he'd understand why it's wise to buy portfolio hedges that expire in December to protect stocks through the remainder of the year, lest Wall Street turn into The Waste Land.
For a small amount of money, investors can hedge their stock portfolios with VIX calls. If the stock market declines, VIX, which is derived from the implied volatility of Standard &Poor's 500 stocks, should rise rather smartly.
Investors might consider buying one VIX December 35 call and selling one VIX December 40 call -- a $5 spread trade -- for a position cost of 85 cents if bought, say, when VIX was at 31.81. If the market tanks and VIX crosses 40, the position could be worth a maximum of $4.15, or the $5 spread minus your 85-cent cost.
Discussions of hedging are often like lectures to kids on why it's good to eat vegetables. No one really likes to hear about it. But don't forget what happened in August. It was supposed to be a quiet month, and then, for the first time ever, the U.S. government's triple-A debt rating was stripped by Standard & Poor's. Debt concerns in Greece, Italy and elsewhere menaced the health of European banks the continent's economic stability. Hurricane Irene badgered the Eastern seaboard. And does anyone really believe that President Obama and Congress will come to an agreement on how to jump-start the U.S. economy and get people back to work?
It's true that the stock market could surge higher, and maybe it is has even already adjusted for lower economic growth. But rather than worrying so much about the hobgoblins of global finance, or sitting around palavering about political solutions, you might protect your investments with a hedge and insure your stock portfolio just like you would your car, or your house or your health.
Comments: steve.sears@barrons.com
http://twitter.com/sm_sears
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