Investors increasingly question how to manage their equity risk exposure as the equity market continues to extend the 9.5 year rally.  Following the “Random Walk” theory, we know markets are subject to making unpredictable price movements and unlikely to go straight up.  Retreating from the recent all-time highs, investors are faced with potentially increasing exposure to equity risk.  There are several alternatives to be considered, such as accept current risk levels, portfolio rebalancing, or stay long and hedge that equity risk exposure.

Equity Valuation – “Buffett Indicator”

One of Warren Buffett’s favorite metrics measures the total U.S. Market Capitalization divided by the U.S. GDP known as the “Buffett Indicator.”  While NO indicator is 100% reliable, the Buffett Indicator as a general rule indicates stocks are undervalued when it’s below 80% and overvalued above 100%.  The Buffett Indicator is currently at 148%, which points to a potentially overvalued stock market.  The previous high was 136% at the height of the Dot Com bubble.  

Source: Advisor Perspectives

Passive Investing and Drawdowns

For the past 5 years, investments in the passively managed portfolios benchmarked to the S&P 500 and Russell 2000 Indexes have performed well.  However, markets don’t go straight up, they typically experience pockets of turbulence.  Within the last 60 months, the maximum drawdowns were -8.36%, lasting 2 months in the S&P 500 and -16.78%, lasting 8 months in the Russell 2000.

 

Collar:

A collar strategy is a cost effective method to purchase downside protection by selling an out-of-the-money call to help finance the purchase of an out-of-the-money put.

                                                         

Using an underlying position in the Russell 2000 Index (1732.35) valued at $173,235, here’s an example of a Collar strategy offering a hedge below -10%  (Buy lower strike OTM Put) while capping the upside by +10.26% (Sell higher strike OTM Call) expiring on December 31, 2018:

Sell 1 Dec. 31, 2018 RUT 1910 Call @ 3.20  

Buy 1 Dec. 31, 2018 RUT 1560 Put @ 15.60

Net cost: $1,560 – $320 = $1,240

Russell 2000 Notional Value = $173, 235

Collar Expense: (hedge -10% / upside capped +10.26%) = .72% of Russell 2000 notional

Conclusion:

Today’s lower levels of volatility create an opportunity for investors to purchase downside protection at a relatively low cost using a Collar Strategy, while maintaining an equity position and more potential upside gains.

Please note, there are various forms of the Collar Strategy to consider. Cboe created several Strategy Benchmark Indexes measuring the performances of various collar strategies based on a hypothetical position using the underlying S&P 500 and Russell 2000 Indexes.  Including the Cboe S&P 500 95-110 Collar, Cboe S&P 500 Zero-Cost Put Spread Collar, and the Cboe Russell 2000 Zero-Cost Put Spread Collar Indexes.

For additional information on Cboe’s Collar Indexes and historical performance, please visit the website www.cboe.com/Benchmarks