Hedging Your 401(k) Brian Cox 4/18/09 Nature is trying very hard to make us succeed, but nature does not depend on us. We are not the only experiment.   - R. Buckminster Fuller

Protecting your 401(k) 4/18/09

Protecting your 401(k) http://en.wikipedia.org/wiki/401(k) With many 401K plans you have the ability to select from mutual funds, stocks, bonds, money market investments or some mix from above. There is some nice reference information on Wikipedia at: http://en.wikipedia.org/wiki/401(k) 4/18/09

Protecting your 401(k) As you know, money is invested on a regular basis. The downside is that you do not have the flexibility of an individual trading account. Most of the instruments that you can select from are heavily correlated to market indexes 4/18/09

Protecting your 401(k) Don’t you wish that you could keep your 401(k) from turning into a 201(k)? 4/18/09

Protecting your 401(k) While there is not much you can do with the your 401(k) as the market drops; but what if you were able to do offset the loss with something that goes up, as the 401(k) goes down? This is referred to as hedging. 4/18/09

Protecting your 401(k) In finance, a hedge is a position established in one market in an attempt to offset exposure to the price risk of an equal but opposite obligation or position in another market. http://en.wikipedia.org/wiki/Hedge_(finance) 4/18/09

Protecting your 401(k) Self Directed IRA 401(k) 4/18/09

Protecting your 401(k) One way to create the hedge is to sell credit spreads in your IRA account to offset the 401(k) loss in value. 4/18/09

Protecting your 401(k) Don Kaufman (ThinkorSwim) instructor, suggested selling vertical call spreads, within the 30-40 delta, every month. That way, if the 401(k) drops or goes sideways, you are collecting income, if the 401(k) rises significantly, the hedge gets hit, but the 401(k) increases in value. 4/18/09

Step 1 select equiv index/etf First determine an equivalent index(s)/ETFs that mimic you’re the mutual funds in your 401(k). Typical ETFs that are SPY, QQQQ, DIA, IWM. The following slide shows that many mutual funds have a beta close to 1 when compared to the S&P 500. 4/18/09

Step 1 (continued) Most funds, despite their names will tend to mimic existing indexes (SPX, DJI, Russell 2000, NASDAQ. The above funds are closely correlated to the S&P 500 (beta close to 1) 4/18/09

Step 2 – calc equiv number of shares Determine the equivalent number of shares that the 401(k) represents. If the 401(k) total value is $143,370 and it mimics the SPY ($143.37), then the equivalent shares is: 143,370 / 143.37 = 1000 shares Convert it to number of contracts 1000 / 10 = 100 contracts 4/18/09

Step 3 – execute trade Execute the vertical call spread in the 30-40 delta range. 4/18/09

Technique: Step 3 – execute trade (cont) The monthly income is $3,500 to offset any drop in value of the 401(k) that you are hedging. 4/18/09

Technique: Step 3 – execute trade (cont) As in all option trades, close out the trade 10-4 days before expiration and then execute the a new spread for the following month. Rinse and repeat every month 4/18/09

Thinkback Calculation 4/18/09

This method of hedging is not perfect. Summary This method of hedging is not perfect. It won’t cover all losses in dramatic drops, but is can offset some lesser loses and in many cases add to the current net value, in a manner similar to the covered call. 4/18/09