Correction or Crash?

You shouldn't really care. Buy protection and weather the storm.

Is the market in a correction mode or are we at the beginning of a crash? I’ve been asked this question quite often over the past few weeks.

The answer is: you shouldn’t really care. Instead of obsessing over the crash, you’ll be much better off if you do some tail hedging.

How? And what exactly is tail hedging? I’ll try to explain in today’s post.

Ever since 2008 I’ve been hearing investors predicting an imminent crash in the next 12 months. Or that hyperinflation is inevitable because the Fed “printed” all that money since 2008. The crash predictions happen literally every year. Almost every quarter actually. Jeremy Grantham predicted a crash of the current “Super-Bubble” in 2021. He doubled down on his prediction last week, predicting the Super-Bubble burst in 2022. Roubini has been calling for a crash every few years since 2010 (google “Roubini/Dr Doom crash 20XX”). Michael Burry described the 2021 bubble as “the greatest speculative bubble of all times in all things”.

These are all respectable investors which have made fortunes in recognizing bubbles before. However, this doesn’t mean they know exactly when it will crash. No one does.

Yes, we are in a big bubble, no doubt.

Every indicator Robert Shiller utilized to uncover the dot-com and housing bubbles is again present. All the structural factors are there, and every single amplification mechanism (hubris, fomo and other narratives, all leading to 'naturally occurring Ponzi schemes') is arguably stronger than ever.

So will a crash happen?

Certainly.

But instead of worrying when it might happen, the smart thing to do is to protect yourself when it does burst.

How? Buy insurance!

In the form of put options. A fancy term would be: do some tail-hedging.

I wanna walk you through a simplified version of what Mark Spitznagel & Nassim Taleb do at Universa (Spitznagel runs the fund, Taleb serves as an advisor). Universa typically delivers over 2000% returns during major market crashes.

How can a small retail investor emulate this approach?

Tail hedging with SPY puts

First of all, it’s called tail hedging because you want to protect yourself from fat-tail events - Black Swans; events which you think have a low probability of occurring but in reality have a much higher probability of occurring. Why? Because the markets don’t typically follow a bell-shaped normal distribution. Their tails are fatter, meaning that huge gains and huge losses are much more likely (have higher probability) than if it were normally distributed. See the image below for clarification:

Source

Ok, so how do I protect myself from such -20/30% market swings?

Buy a put option.

Let’s use an example. Say you’re just following the S&P500 and only have a portfolio with exposure to the SPY ETF.

To protect yourself from a major decline in the S&P, you can use 3% of your portfolio to buy a SPY put option w/h 2 month expiry (so Mar 31st if buying today).

Aim for the put to be about 25-30% out of the money (for example, buy the 350 strike).

If S&P falls 20%, you break even and have no losses.

If if falls more, you earn money.

You can typically calculate your potential gains and limited losses via your broker account, but even before doing that, I recommend using the @unusual_whales options calculator. It is very straightforward and user friendly.

Source

There you can calculate exactly how much you need to invest to stay protected. For example, if you have $10,000 invested in SPY, you buy one SPY 31/03 put for $215 (2.15% of your portfolio).

If SPY goes down 20%, you pocket exactly $2,000 from the put, thus limiting your losses entirely and breaking even. If it goes down 30%, you get $4,500, so even more than you lose on your long holdings. And so on. The bigger the decline, the more you benefit.

If, however, SPY goes up, and you already hold long positions in it, you’re still fine.

You lose only part of your insurance contract, in this case about $200 each month.

IMPORTANT: You’re buying a put with 2 month expiry. You need to update this position each month. So by Feb 28th, sell the current put (if markets keep going up, it will lose a lot of its value by then), and buy a new one, again with 2-month expiry (April 29th).

Keep repeating this at the end of each month.

You will be losing only a fraction of your portfolio (which you will more than compensate when the markets recover), but you’re protected in case of a crash.

And you never have to worry about timing the crash.

When it happens, you'll be fine. You're protected.

Note, however, that this is most applicable in case of a major crash. If market remains anemic (don’t go up or down by much), with low volatility, you won't really gain much. But you’re still protected, and don’t have to stress over its performance. In that case you are ready to weather the storm regardless if this were a correction or a crash.

Btw, you can do the same for each stock holding you have. For example, if you have a big TSLA position calculate how much you could have gained with a tail-hedge protection over the past month.

In conclusion (TL;DR),

Don't obsess on whether the market is crashing.

Protect yourself against losses with an easy put strategy:

Buy put options (2-3% of your porftolio) at the end of each month with 2-month expiry. The puts should be 25-30% out-of-the-money (put strike 30% lower than current stock/ETF price). Sell the put at the end of the month and replace with a new one. Repeat :)

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