Ways to hedge Trump rally returns

IOn the Contrary nvestors have experienced some strong gains in equity markets since the election of Donald Trump to the White House. However, it hasn’t been just the S&P 500 that’s benefited as other markets have rallied as well — since the election the S&P 500 is up 12.5 per cent, the MSCI EAFE index is up 12.1 per cent, the MSCI Emerging Market index is up 8.1 per cent and here in Canada our S&P TSX is up 7.8 per cent.

To add some further perspective, we’ve read that the total global equity market capitalization has now gained a whopping US$3.3 trillion over this period or more than two times the size of the Canada’s entire equity market.

What started out as a fiscal stimulus trade in the U.S. has now spread abroad with repositioning for the upcoming commodity rebound and global reflation trade with the recent quarterly results from Caterpillar adding more fuel to that fire. Interestingly, commodity prices, and especially oil, have yet to respond as they did this time last year. The forward expectation, however, is certainly very rosy with pundits looking for a repeat.

Not surprisingly, the level of volatility in the equity market, as represented by the Vix, has now fallen to levels not seen since the market top in 2007. The short interest (in nominal shares) on the S&P 500 has also fallen to its lowest levels since just before the start of the financial crisis.

With these record levels of complacency, investors have begun return-chasing, once again choosing to go full risk-on. According to a recent BAML report, there was a US$21-billion inflow into global equity funds in the latest week representing the largest level of inflow since the election. It also isn’t just equities investors are chasing as junk-bond yields have fallen to 5.65 per cent, which is lower than 97 per cent of historical readings according to Charlie Bilello at Pension Partners.

In this type of environment where risk premiums have become diminished, we think it really helps to take a step away from the crowd and perhaps even start to hedge a portion of one’s gains. While this could mean rebalancing or adjusting one’s asset mix there are some other ways to hedge some of these gains without having to actually sell a position.

In particular, this is where the option market can prove very effective offering various levels of protection for those fully invested.

The first method would be using a portion of one’s gains to purchase a put contract on the underlying position. Purchasing a put is the only sure way to protect one’s position while still participating in future upside as other strategies such as stop losses are not nearly as effective.

For example, someone long the U.S. equity market since the election could purchase put options such that in a worst-case scenario they would lock-in an approximate 8.5-per-cent floor return through to September (nearly one year). Should the market continue to rally from now until then, they will participate, less the 2.5-per-cent cost of the put and in a flat market scenario, they will have still generated a healthy 10 per cent return on the position.

The second method would be to add some income to the position by selling a covered call.

For example, someone long the MSCI EAFE market since the election could sell an at-the-money call option through to September and add another approximate 2.5 per cent to the 12.1-per-cent return. That said, this means giving away all of the upside beyond this 2.5 per cent but should the market correct this premium will offset some of the downside.

Finally, one can look at doing a combination of both and implementing what is termed as a collar. This means buying an out-ofthe-money put and selling an out-of-the-money call. For an investor who owned the MSCI Emerging Market since the election they can create a near one-year return profile of 2.0 per cent to 14.0 per cent through to September thereby offering some material protection against a market correction while retaining some attractive upside.

There are many other more complex multi-leg strategies an investor can utilize to protect and grow their positions, but the point is that an investor always has options. The question is whether they wish to use them or choose to be with the complacent majority.