Experts Advise Precautions Against Geopolitical Risk

America Iran Conflict

With the potential for conflict between Iran and the United States at hand, while we should not overestimate the risk to stocks, some are advising that we hedge our bets.

Stock markets don’t like conflict, and especially do not like ones that risk putting up the price of oil considerably. While President Trump certainly raised the stakes in his confrontation with Iran by ordering U.S. forces to assassinate Iran’s top general Qasem Soleimani, with Iran vowing revenge, this in itself is little reason to worry.

Unlike Iraq, Iran would be a formidable foe on the battlefield, and this has never been a country that it would make sense to go to war with, as the costs would be very high and the benefits insignificant in comparison. If people are upset with a few Americans losing their lives to Iran’s state sponsored terrorism, the cost would be orders of magnitude higher if an actual war broke out.

While Iran may threaten war, this can’t possibly be what they want, as they would not fare well against America’s air supremacy. The U.S. does not have to try to occupy them or even use ground forces to do plenty of damage to Iran. If the U.S. did go all in with this, this would come at a real cost, both in terms of money and lives, because Iran will indeed fight back. Even President Trump understands that the benefits must justify the costs, in spite of his apparent impetuousness, and now that the attack is over, the talk on the American side is not of escalation, but de-escalation.

The Iranians may want their eye for an eye, but need to make sure they don’t lose their other one in the process. They certainly realize that any retaliation may be met with another response, and the best decision that they can make is to call things even and not provoke the Americans further. That won’t be easy for them to do, and the Ayatollah not surprisingly wants blood, but hopefully cooler heads will prevail, for their sake mostly.

Iran isn’t one of Donald Trump’s favorite countries as it is, he certainly can be expected to respond to any direct attack on American interests. The most likely response, to get things under the radar enough, would be more attacks on their neighbors, like hitting Saudi Arabian tankers or wells or those of another country in the region that they are willing to attack.

Their response must also be measured, and not cross the threshold of invoking Trump’s ire again to the point where both sides trade blows for a while. Iran is virtually assured of the worst of this if this happens, and they haven’t stayed out of the crosshairs of the U.S. this long by acting too foolishly, which escalating this incident too much would turn out to be.

While a ground war in Iran would be difficult and costly for the United States, picking them off with airstrikes is right in their wheelhouse, and this has to be seen as a real threat by the Iranians, and therefore they would be expected to avoid such a showdown. Sure, they have their own methods of insurgence, but if they persisted with such things, this would really put the price they have to pay for this up.

The risk here is therefore pretty limited, and we didn’t even see spikes in oil prices this time like we saw with the Saudi attacks, even though that didn’t last very long and wasn’t expected to, as we spoke about at the time. This neither had a lasting effect on oil or stocks, although both markets got rattled and overreacted, as they tend to do.

Even though Friday’s selloff took us away from the all-time highs we’ve been accustomed to, the response of the stock market was measured enough that we’re still higher than we were to start the year, and the selloff on Friday didn’t even take away all of the move up the day before provided. Given that the biggest reaction in the stock market happens right out of the gate, this one isn’t open very far.

It’s not this event that people are worried about, it is the threat of the Iranians busting open this gate that has people concerned. Trump is not Jimmy Carter, and far from it, and we can only imagine what Trump’s response would be if he was faced with something of that magnitude, although talking or hoping would not be on the list. If Iran was afraid of Ronald Reagan, they need to fear Trump all the more.

If We Want Protection from This Risk, What’s the Best Way to Pursue It?

This brings us to the matter at hand, what investors might want to do in order to protect themselves from this geopolitical risk. Whether we want to do anything right now is an open question, and if we do choose to hedge against this risk, we need to be aware of its costs in order to decide whether it is worth it or not and whether something else might be better.

Using options in various ways to hedge this is being thrown around now in the media, which on the face of things might seem like a good deal. Options aren’t as cheap as they are held to be by those who favor this strategy though, and we especially want to be careful with hedging against short-term moves that may not even have any consequence to our overall investing strategy.

Imagine an investor hedging against more attacks on Saudi Arabian oil production last year. Whatever you spent on this would have been wasted, and the risk to investors on a long-term time horizon would have been pretty meaningless, so it’s not that this saved us against a real crisis that could have hurt us enough to even need to worry about.

Hedging with options is a curious strategy that turns out to only be a good idea if there are no other options. It may have its place though, as there are cases where people are stuck holding on to their stock positions regardless, by way of a blind trust for instance or company restrictions. More commonly, people will want to hold their stocks in the bad times as well for tax purposes, even though we can be blinded by this enough to pay a bigger price for hanging on than by saying Uncle and paying the tax.

We have to pay taxes on these profits at some point, and while it is always better to delay this, if we do so in a way that yields a net loss after the tax considerations are accounted for, that’s not what we should be doing. It doesn’t take that big of a move against us to make holding and avoiding declaring capital gains a bad idea in fact.

We also need to be careful not to play our options flute and entice a lot of neophytes into this game. There are no free lunches with options, but you can’t appreciate even this if you know little about them, and few investors have much of a clue here, and as they say, they don’t know what they don’t know.

We see ads on TV from brokers such as TD Ameritrade telling us that you can just read a little info that they have for you on options and then off you go into this exciting world of trading. Hedging is at least less complicated than using options to speculate, which for the unskilled, this is like wanting to be your own doctor after watching a few episodes of Dr. Oz. Hedging is much simpler but still requires some sort of genuine understanding to even know what we are buying or whether the price is worth it.

Let’s look at the simplest of these approaches, which would be buying index puts. If the index drops below a certain amount, we can make a profit from the option to offset our losses with our stocks, and if we are wrong, the cost seems small in comparison to the monster we have summoned to scare us. In a real sense, hedging with options involves choosing better weapons to use against the monster, rather than just running away and making it completely disappear.

The first cost that we need to calculate is the potential loss in our stock positions, and this part applies to the whole move down, and especially the room down to where our puts get in the money. To make sense of this, we have to be generous with this room, otherwise we will be paying way too much for it and even enter the world of options speculation, and become sheep to be fleeced by the professionals.

A lot of the options recommendations that you see out there in the media are actually speculative, and this current situation isn’t immune from such things, where investors are told to buy puts much closer to the money than a hedge would require. This sort of thing is outside the scope of this discussion, but is a much more challenging game to win at than we are led to believe.

We also see the payoffs as bigger benefits than they actually are, and do little or no math here, and not even think very much about what we are doing. The price we pay for the options will already have the risk priced in, and this will much better capture it than our off-the-cuff worrying ever will. If we see them as a deal, we are either sharp enough to out-think the pros, or we are overestimating the risk and will be undressed by the market.

Risk management doesn’t involve seeking to improve our profits though, so we shouldn’t be put off by this having a cost, it’s just that we don’t want to pay too much and we also want to make sure that we are protecting ourselves in the best cost-efficient way that we can and not just jump at the first idea that we are presented with.

This sort of thing makes the most sense if we are looking to hedge against black swan events, the kind that can bring the market down violently in a single moment, where we can use very long options to at least ensure that we come out of such a thing with our shirts. In this case, the cost is very low, and while the likelihood that we’ll ever have to use such a thing is also very low, when we factor in the peace of mind that this can provide, it can end up being worthwhile for at least some, the real worriers.

We always need to realize that options already price in the risk that they protect against, so whatever benefits that we think that we will be getting for this, we will be paying for them in the options premium, which goes up in price when these things hit the street. This is a losing proposition on balance in fact, but all insurance is, but like insurance, we need to shop around if we are looking for the best rates.

Being Exposed to More Risk and Paying for It is Not a Good Plan at All

The biggest reason, by far, why using options to hedge bear moves is not a good idea escapes just about everyone, because they will first choose to assume all risk and then look to hedge that with something else. If we assume that the only two alternatives are to hedge with options or just hold our stock positions unhedged regardless, option hedging may indeed seem appealing, but if our fingers are on the trigger enough to want to pay for these options, this can also be used to just run away instead if needed.

The reason why we may want black swan protection is that these events just appear out of nowhere and instantly beckon a nightmare. We have never seen such a thing or anything close to it in history though, and instead of being dealt a devastating blow, the bleeding that goes on with these things happen much more slowly, and we can avoid most of it just by escaping it.

We shouldn’t want to pay for something that provides us more insurance than we need. By the time we get down to actually seeing the hedge kick in, the writing is all over the wall and the only thing we should be asking ourselves is why we held this long and suffered this much loss.

We sometimes should be selling before we ever get as far down as people would want to buy a put at, so this not only isn’t a good deal, it causes us to make bad decisions and actually pay a premium to make them.

Options continue to be shamelessly promoted as a hedge, and those who do so obviously don’t get any of this. We’d be a lot better off using stops to do this as they are at least free and we can set them where we want and not have the options market influence this.

If we are really worried about a sell-off from things like this, we could just determine what our risk threshold is and place a stop there. The worst-case scenario here is that you get stopped out and then the market rebounds, but this is where you get back in, and this can save you a lot of pain if things just keep going down, as they often do. The slippage in the transition in the unusual situation where we do get out at the bottom is well worth paying, as the goal is to avoid going deeper into the water, which is exactly what stop losses do.

Hedging with options functions like stops but are the ones that you need to pay for, and it’s just better getting something even better for free.

Options that blunt our losses should things turn against us actually cause us to lose money. We pay a price regardless, and if the mud hits our windshield, we typically look to be covered for most of our losses, 80% for instance, which means that as things move down further, we are still subject to losing 20% of the move all the way down of it instead of being in a safe place waiting for the storm to pass.

It’s better not to pay for the privilege of losing more money, but we need to lose our investing religion first, the religion that worships a god that just tells us to hold stocks, and recognizes no other. Once we free ourselves of this, we can see just how much sense stop orders make with capping our risk, like traders need to do lest they get thrown upon the rocks and die an ignominious death. Investors can learn a lot from traders, if they only would listen more.

By placing a stop-loss order where we would instead have wanted our hedging from options to kick in, in both cases we suffer this loss, but with using stops, we not only avoid paying a premium for this, we fully protect ourselves against further losses, not just partially, at a time where things have clearly turned sour enough that the odds have not only turned against us but they threaten to hurt us a lot more. Getting slapped some more instead of punched is preferable, it’s just better not to be looking to trade blows with the market when it becomes this angry.

We could buy enough options to cover off the whole risk below our threshold, but that costs even more to end up in the same place as stops and we shouldn’t be paying anything extra here.

If we actually did this, then the options hedge would function just like a stop, capping our losses right at the point where they kick in. We not only pay the price for this, we also forego any opportunity to profit from the rebound when it happens, as we are still chained to the stocks instead of getting to buy them back cheaper.

If we ever feel uncomfortable with the degree of our exposure to stocks, there’s nothing stopping us from taking some off the table, and while this can cost us gains if we are wrong, at least we don’t have to pay extra on top of that. Waiting for the fireworks that we are so afraid of actually go off and not just be a matter of speculation, even beneath the threshold of plausibility, is another way to manage the risk here, provided that we do not act like deer in headlights and become captured as a prisoner of war for the duration, instead of choosing safety and freedom.

If we are serious about protecting ourselves against further developments in this squabble, and want to limit our potential losses, we need only follow Trump’s lead and just issue the command.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.