By: Steve Smith
Lately, the stock market seems to hit new all-time highs every other day. And the gains are coming in a grinding, methodical fashion, causing volatility to sink to historically low levels. Given this combination, you’d think investors would be rejoicing. But instead we’re getting a lot of questions about how protect or hedge their holdings. Today, we’re going to answer those questions using options trading.
This widespread insecurity speaks to not only the underlying ‘wall of worry’, but also the increasing sophistication of investors that have been taught that low volatility also can be translate into ‘cheap’ portfolio insurance via the purchase of put options, or more recently volatility products related to the VIX.
While it is essentially true that ‘put protection’ is now less expensive on a relative basis than it was in the past, it can still prove quite costly on an absolute basis in terms of the drag on your returns.
Two of the mistakes investors make in using puts for hedging protection are:
- They buy more insurance than is needed relative to their holdings or risk profile
- They buy puts that outright that are too far out-of-the-money which only provide only “disaster protection” rather than buffering more likely instances of 10% decline.
Let’s look at some of the concepts for buying the right and appropriate portfolio protection.
In my options trading, I try to have individual positions that have their own internal hedges by using spreads. These usually take the form of basic vertical spreads in which you both buy and sell options with the same expiration but different strike prices.
The essential function of a spread is to reduce the cost and mitigate the impact of changes in implied volatility and the negative impact of time decay time.
I also frequently use options on the Spyder Trust (SPY) to provide the overall portfolio with broader protection. Typically, individual positions tend to be bullish, while the portfolio protection chunk usually consists of the purchase of puts or put spreads. Let’s take a look at how this concept can be applied to a less active and basically bullish-oriented options trading portfolio.
Buying put options does offer the most complete and probably efficient way to hedge a position, but it comes at a cost. That cost, as with all insurance policies, will be a function of the amount of protection and its duration.
The main items to consider when choosing put protection, whether for an individual stock or a broad equity portfolio, are as follows:
What magnitude of a decline is expected?
At what level of the decline do you want the position to be fully hedged or protected?
For what length of time do you want the protection in place?
Answering these questions will help you determine the appropriate number of puts to buy at a given strike with a certain expiration date. By using the basic application of delta in which an at-the-money option is expected to move $0.50 for every $1 unit price move in the underlying security, one can begin to assess how much and at what levels cost protection can be purchased.
If you’re really looking for a true, longer-term hedge — that is, you don’t expect to make many changes or adjustments to your portfolio for six months or more — using a combination of strategies might make sense.
For example, I suggest the following three-step approach, which uses SPY options to create portfolio protection for a $150,000 portfolio:
1. Buy a put spread of closer to-the-money strikes that have about six months remaining until expiration. With the SPY trading around $280 one can buy the January2019 275 puts and sell the January 260 puts. Such a spread could be bought for around $3.00 net debit. For a $150,000 portfolio, purchasing about 100 of these might provide reasonable protection. But because we’re protecting it in two ways (read on), buying 25 spreads should suffice.
2. The next step is to sell a call spread for a credit, such as selling the January 300 calls and buying the January $310 calls. This call spread can garner about a $2.50 net credit. Remember, as a spread, this won’t limit your upside. You could probably sell up to about 50 or 60 of these spreads.
Just be aware that there’s a “dead zone.” If SPY is between 300 and 310, then you’ll lose $7.50 on this position. But I assume you’d be making money if stocks rallied another 10% or $20 SPY points from current levels. You can use higher strikes or sell fewer spreads to align with your risk profile.
3. Finally, use the proceeds of the call spreads to buy some out-of-the-money (or OTM) puts outright to provide deeper downside protection. For example, the $7,000 proceeds from the call spread would finance the purchase of about 20 of the January 250 puts. These OTM puts give you outright disaster protection should the market incur a 10% or greater decline.
The total outlay would be about $11,000 — or about 7% of the $150,000 portfolio — which isn’t too steep for over 11 months of portfolio insurance.
This is just a loose construct — you can play around with the numbers — but I think the best hedges will ultimately involve more than simply picking one strike.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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