Short the Euro as Cheaper Alternative to Puts on the S&P500

Managing tail risk is a constant worry for any investor using leverage, and many others who shouldn’t worry since they’re not levered also fret over the possibility of a market swoon. It’s a real dilemma; low risk assets such as government bonds offer no return at all unless a flight to quality drives prices temporarily higher. Risky assets such as equities are attractively priced as long as (take your pick) (1) housing doesn’t turn down, (2) Spain doesn’t need a bailout, (3) Israel doesn’t bomb Iran. As someone once said, you can have cheap markets and safe markets but not both at the same time.

Buying equity put options can afford some protection but of course the option premiums will eat into the return. Long stock with a put is equivalent to a long call, and buying call options isn’t generally a reliable way to build wealth. We started looking at using a short Euro position last year in combination with risky assets. The logic at the time was that most of the bad things that could derail the market were likely to begin in Europe. While that’s not as obviously the case today, it can still represent an attractive way to combine risky, yield generating assets (such as bank debt) with a market hedge.

The 90 day rolling correlation between the S&P500 and the Euro has moderated from its high levels in the Fall when the Euro crisis dominated the news. However, while day-to-day moves are fairly independent of one another, the Euro reliably drops when stocks are notably weak. Over the past year, the Euro fell 69% of the time when the S&P was down 0.25% or more. Falls of 0.5% or greater saw a weaker Euro 90% of the time.

The U.S. is likely to experience GDP growth of 2.5-3% greater than the Euro-zone this year. The focus on austerity as the solution to Europe’s excessive debt makes a weaker currency in their interests as a way to stimulate some demand for southern European exports. So a short Euro position is probably the path of least resistance barring another crisis, but in addition it provides some tail risk protection for holders of higher yielding assets.


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