Is It Too Late to Hedge Against Another Stock Market Crash?

Investors frequently want to find ways to protect their assets from a crash without selling everything they have and going into cash or bonds. On days when the Dow falls over 900 points, most investors wish they would have hedged with put options or selling out of some stocks ahead time. The question that needs to be asked after the close of October 28, 2020 is whether or not it’s too late to protect your portfolio of stocks from yet another potential market crash after a 943 point Dow drop.

Be advised that this is not a prediction of a stock market crash. In fact, defining a crash versus a sell-off is something that many investors cannot even agree upon. That said, next week’s election comes at a time that the nation is more divided than it has been in more than a generation, and many headwinds are against the stock market at this point in time.

The number of COVID-19 cases keeps climbing, and fresh lockdowns are being seen in Europe again. With no vaccines yet approved, and with some recent mixed reactions and halts in the Phase III studies, the hope of widespread vaccinations seems to be looking further out than had been hoped.

Earnings from major companies are getting very mixed reactions from the market, with many major stocks falling even on great earnings. Another issue is that the live economic reports are still showing mixed signals about the recovery. And for those never-ending stimulus negotiations, that’s toast. And to top it off, more civil unrest in some larger U.S. cities has come back into the news.

After a 3.5% drop in the S&P 500 and a 3.7% drop in the Nasdaq Composite, the CBOE Volatility Index (the VIX) closed above 40 (up 20.7% at 40.28). The VIX is also called “The Fear Index” by many investors, and the higher it goes the more fear there is. The problem with a rising VIX is that it usually means that buying put option protection for the major indexes, or stocks or ETFs, usually becomes very expensive.

Wednesday marked the highest closing price on the VIX since June 11, 2020. For a reminder in trading history, June 11 was also the day that the Dow fell more than 1,800 points (about 6.9%) in a single trading day that brought up worries of a return back to the selling panic in March. And while the market retested the lows again in June, it should at least be considered that those days were the lowest the markets have been since. Even after Wednesday’s 943 point drop, the Dow is still 5.5% higher than back then.

The Bank of Japan (BoJ) and the European Central Bank (ECB) are also set to announce monetary policy decisions on Thursday, and China’s Communist Party Central Committee is meeting this week to determine its course for economic development over the next 5 to 15 years. And to add more fire, the Brexit negotiations are expected to run through mid-November. If that all is not enough, the U.S. will get to see a first view of the third-quarter Gross Domestic Product (GDP) on Thursday as well.

Most ETFs tracking Europe were down over 3% or 4% late in Wednesday’s trading day. The problem there is that with massive drops in Europe and the U.S., the MSCI Asia Pacific Index was only down by about 0.5%. That could mean they have some catching up to do in Thursday’s trading. The iShares MSCI Emerging Markets ETF (NYSE: EEM), which is dominated by Chinese stocks, closed down 2.5% at $44.77 on Wednesday.

Where this rapid decline in stocks that has been seen this last week gets tricky is in Treasury yields. The 30-year long-bond yield of 1.57% on Wednesday is down just 2 basis points since Monday and is down only about 9 basis points since peaking on October 22. The yield on the 10-year Treasury yield of 0.78% is down just 2 basis points in the last 2 trading days and is down just 7 basis points from the same October 22 recent high.

The Federal Reserve has all but written in blood that it will not be raising interest rates very soon. Many stock market investors who believe the bond market is a better live-money poll of the economy would think that this means the stock market reaction is overblown.

The breadth of the stock market was atrocious on Wednesday. Only one of the 30 Dow stocks closed up on the day, while only 14 of the members in the S&P 500 index closed positive on Wednesday. In short, it was a washout day where only company-specific news winners rose on the day. Even the defensive stocks closed dower on the day as Utilities and defensive Consumer Products giants were down about 3% on average. In fact, all sectors were lower on the day. Even gold fell by 1.5% to about $1,877 per ounce, and crude oil was last seen down almost 4% at $37.40 late in the trading day.

As for looking at options as a tool now to protect a portfolio against a market crash, the price to enter that party may already be too high. The options that expire next Friday, after the presidential and national election, which were at-the-money on Tuesday’s close effectively doubled in price and the implied volatility surged on Wednesday’s sell-off.

Investors who hedge their portfolio with put options as an insurance policy tend to sleep rather well on days when major drops are seen. That said, buying put options against the major indexes and against the high-flying top stocks of 2020 is now rather expensive. It won’t do much good at the present to say that hedging portfolios and positions should have occurred a week ago or earlier, but unfortunately that is how things are looking after another major down day in the stock market.

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