How to protect against greater stock risk and smaller returns this year
The U.S. stock market just wrapped up a year offering its best annual return relative to low risk-taking in 20 years. But now, risk is likely to rise and complacency could be costly for investors, according to some analysts.
Quick math shows how little investors had to put on the line to have a solid 2017. The average long-run historic stock market return of 8% normally comes with a 15% standard deviation. The more a stock’s return varies from its average return, the higher the standard deviation—and the more volatile the stock. That means investors typically have to take a certain amount of risk to achieve even this long-run average return.
But last year, stocks broadly offered a 22% return while the standard deviation was just 6.7%, according to Joanne M. Hill, chief adviser for research and strategy at Cboe Vest, the asset management subsidiary of Cboe Global Markets, which is also the holding company of the Cboe Options Exchange.
Another measure shows how quiet volatility was during 2017’s standout performance. Indeed, a measure of implied volatility—the Cboe Volatility Index VIX, +1.82% —still hovers around 10, near historic lows, and at less than half its historic long-run average at 20. The VIX, which has no real predictive power but nonetheless captures investor attention as a short-term thermometer of risk, measures expectations for volatility, or stock movement, over the next 30 days.
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In a scatterplot of annual returns relative to risk from the last 30 years, Hill says that the return from 2017 stands out. “Similar high returns with relatively low volatility were observed in 1989, 1991, 1995, 1997, and 2013,” she wrote in a note to mostly institutional investors.
“Our analysis suggest that we are unlikely to see the repeat of 2017: the stock market will return less, while risk will be higher,” Hill said in an interview with MarketWatch.
“This is a great time to implement strategies that would reduce downside risk and the good news is that investors can do it at a low cost as option prices are pretty cheap right now. As soon as volatility picks up, so will options prices,” Hill said.
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Normally, investors who are holding equities and believe there is a risk of a market downturn would buy put options, which give an investor the right, but not the obligation, to sell a security at a certain price, known as the strike price, by a set time.
If the market drops, investors conceivably would have protected their returns by selling at a predetermined price. Investors’ losses would be limited to the premium paid, the cost of “insuring” against a downdraft (call options, conversely give investors the right, but not the obligation, to buy a security at a certain price by a set time).
Protecting downside risk, as good as it sounds, isn’t without costs, however. Buying put options, often referred to as “protective puts,” for example, eats into returns over time as investors are paying premiums.
“It is true that our fund has a drag from paying premiums on protective puts, but we still think it is worth protecting against the tail risk,” said James Abate, chief investment officer at Centre Asset Management LLC.
But rather than buying protective puts, investors should consider selling options instead, according to Hill.
Normally, the vast majority of both put and call options expire worthless. However, writers of options make money collecting premiums, in the same way that insurers make money offering insurance products.
“An institutional investor, who has a mandate to have a certain allocation to stocks, could convert a portion of the portfolio into cash and sell put options backed by that cash, which ultimately gives them exposure to equities at lower prices,” Hill said.
“This way, they have reduced risk, but not the exposure. If stock market falls, they will buy shares at a lower price. If the stock market rises, their loss is an opportunity to participate in an upside,” Hill said.
“Selling covered call options is another way to enhance returns of a portfolio,” Hill said.
Those who are buying puts would be prudent to buy long-term contracts to avoid constant rolling and trading costs. But those who are selling put options would benefit from shorter-term contracts to take advantage of volatility, which is likely to be higher, according to Hill.
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“The size of the pullbacks would depend on the catalysts. If [the move is] due to specific company news, such as earnings, then the dips would be shallow,” Hill said. “However, negative events that are macro are likely to result in deeper drawdowns. Either way, we expect more volatility over the next 12 months.”
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