Is it possible to detect a financial bubble and predict when it
will burst? Dr. Didier Sornette, a former physicist who is the
director of the Financial Crisis Observatory in Switzerland,
developed a statistical model designed to do just that. Sornette
and his colleague Anders Johansen determined in 2004 that in two
thirds of the cases where financial assets suffered extremely large
drawdowns, market prices followed a "super-exponential" behavior
prior to their occurrences. According to mutual fund manager and
former finance professor Dr. John Hussman, the Sornette model is
predicting a stock market crash as early as next
On Twitter last week, Hussman wrote:
"In order to push out finite-time singularity on a Sornette
bubble, it has to become more vertical. There's a limit, and
we're close to it."
Hussman elaborated on his prediction with the graphic below.
The Problem With Crash Predictions
One problem with crash predictions is that if you sold all of your
stocks or stock ETFs every time you read one, you would have missed
out on the entire cyclical bull market since the March 2009 bottom.
Still, it wouldn't be prudent to ignore the risks. By hedging, you
can continue to participate in the current bull market, while
protecting yourself if the crash comes to pass. Below, we'll show a
step-by-step way to hedge a $1,000,000 equity portfolio.
How To Hedge a $1,000,000 Portfolio
Step One: Choose a Proxy Exchange-Traded Fund
Although some stocks can't be hedged directly, you can still
hedge a diverse portfolio of mutual funds and non-hedgeable stocks
against market risk by buying optimal puts* on a suitable
exchange-traded fund, or ETF. The first consideration is that the
ETF will need to have options traded on it, but most of the most
widely-traded ETFs already do.
The second consideration is that the ETF be invested in same asset
class as your portfolio. Let's assume your portfolio consists
mainly of large cap U.S. stocks (NYSEARCA:IWB). An ETF you could
use as a proxy would be the SPDR S&P 500 ETF (NYSEARCA:SPY),
which, as its name suggests, tracks the S&P 500 Index. You
could then enter its ticker symbol, SPY, in "Ticker Symbol" field
in the Portfolio Armor iOS app, as in the screen capture below.
Step 2: Pick A Number Of Shares
In order to hedge a $1,000,000 equity portfolio against market
risk, you would want to hedge an equivalent dollar amount of your
proxy ETF. Since SPY closed at $177.29 on Friday, you would simply
divide your portfolio dollar amount, $1,000,000, by $177.29, and
enter the rounded quotient, 5460, in the "Shares Owned" field, as
in the screen capture below.
Step 3: Pick a Threshold
Threshold, in this context, means the maximum decline in the value
of your position that you are willing to risk. If you weren't sure
of that, you could click on the question mark to the right of the
Threshold field above, and you'd see this explanation in the screen
What is the maximum decline you are willing to risk? Generally,
the larger the decline, the less expensive the hedge, and
vice-versa. In some cases, a threshold that's too small can be so
expensive to hedge that the cost of doing so is greater than the
loss you are trying to hedge. I generally use 20% decline
thresholds when hedging equities, an idea borrowed from a comment
by John Hussman:
"An intolerable loss, in my view, is one that requires a
heroic recovery simply to break even ... a short-term loss of
20%, particularly after the market has become severely depressed,
should not be at all intolerable to long-term investors because
such losses are generally reversed in the first few months of an
advance (or even a powerful bear market rally)."
Essentially, 20% is a large enough threshold that it reduces the
cost of hedging but not so large that it precludes a recovery. So
we'll enter 20, in the Threshold field below, and tap "done", as in
the screen capture below.
Step 4: Find the Optimal Puts
A few moments after tapping "Done", we'd be presented with the
optimal puts. The screen capture below shows the optimal puts, as
of Friday's close to hedge against a greater-than-20% drop in SPY
over the next several months.
As you can see at the bottom of the screen capture shown above, the
cost of this protection was 0.93% of your position (portfolio)
How This Hedge Would Protect Your Mutual Fund
Remember, the reason we picked SPY in this case is because our
hypothetical investor's assets were invested in large cap US
stocks. If those equity assets drop in value due to a market
decline, most likely, the S&P 500 Average will have dropped as
well. And if the S&P 500 has dropped, the ETF tracking it, SPY,
will have dropped as well. If the S&P 500 drops more than 20%
-- if it drops 20.5%, 30%, 40%, or even more -- the put options
above will rise in price by at least enough so that the total value
of a $1,000,000 position in SPY + the puts will have only dropped
by 20%, in a worst-case scenario.
Put options move in a nonlinear fashion, which enables a small
dollar amount of them to hedge a much larger dollar value position
in an underlying security. For an example of this nonlinearity in
action, see this recent post about a hedge on Tesla Motors (
Hedging a Portfolio Of Stocks And Bonds
The example above is simplified in that we've assumed our
hypothetical investor's portfolio is entirely invested in equity
assets. But what if he had some bonds or bond funds? In that case,
we could use a similar process to hedge his portfolio against
market risk, except instead of using just one proxy ETF, we'd use
one per each asset class. So, for example, if 60% of the investor's
assets were in blue chip US stocks, and 40% in US Treasury bonds,
he might scan for optimal puts for a $600k position in SPY and
thenscan for optimal puts for a $400k position in the iShares 20+
Treasury Bond ETF (NYSEARCA:TLT).
*Optimal puts are the ones that will give you the level of
protection you want at the lowest possible cost.
uses an algorithm developed by a finance PhD to sort through
and analyze all of the available puts for your stocks and ETFs,
scanning for the optimal ones.
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