Systematic risk is a term used to describe the probability of a broad-based market meltdown occurring. Although comprehensive market crashes are rare, traders and investors remain vigilant in limiting exposure to such events. This goal can be accomplished in a variety of ways, with the execution of futures and options hedging strategies being near the top of the list.
For active financial market participants, systematic risk is a key factor in the decision-making process. In many ways, it is unquantifiable, functioning as a true “unknown unknown.” Pragmatically, who can know exactly when an entire market or sector will crash? Arising from both obvious and obscure market drivers, these phenomena typically develop quickly, so how can anyone prepare for such scenarios?
Although it’s true that accurately predicting market crashes is inherently difficult, being ready for one isn’t. Although traditional portfolio diversification is not much help in regards to a total or multisector market meltdown, hedging with futures and options is. Here are a few periodically implemented strategies (monthly, quarterly, or yearly) to hedge against catastrophe.
Purchasing at-the-money (ATM) or in-the-money (ITM) put options allows you to sell a product at its current value at some point in the future. If the market crashes, then exercising the put becomes extremely lucrative.
A straddle is a strategy in which a trader simultaneously buys a call and a put option for the same contract, with the same strike prices and expiration dates. The only risk to the trader is the premium paid, with a market crash opening the door to theoretically unlimited profits.
Buying and holding deferred-month safe-haven futures can provide insulation from a sudden market downturn. However, this strategy functions best in the intermediate-term, because a financial panic can send all assets temporarily lower.
Stocks are viewed as the riskiest asset class and the premier indicator of a market crash. By shorting deferred-month equities index futures, you can reap big rewards from a sudden, severe bearish move in pricing.
When faced with a broad market downturn, the strategies above are a few ways in which you can address systematic risk. Many professional traders also believe that “hedging out” the U.S. dollar by executing inter-commodity spreads is an ideal course of action. Ultimately, a trader’s imagination is the only thing limiting the development of new and effective risk management strategies.
The onset of the coronavirus (COVID-19) pandemic in March 2020 brought levels of market angst last seen during the global financial crisis of 2008. Equities markets around the world crashed, led by massive selloffs in the DJIA, S&P 500, and NASDAQ. Commodity pricing also plummeted as the value of the U.S. dollar posted a dramatic short-term rally. For those with a high degree of market exposure, staggering losses were taken as systematic risk spiked.
Although hindsight is always 20/20, a few of the strategies mentioned above could have helped to limit the financial damage of COVID-19 hysteria.
It’s easy to look back on a market crash and build a winning strategy. It’s also easy to pick last week’s winning lottery numbers. Unfortunately, that’s not how life works. The key to navigating a market crash is to be proactive rather than reactive.