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This article was written to help investors protect their portfolios from market risk over the next few months. Because holders of the index are sitting on phenomenal twelve-month gains, many individuals are ready to lock in profits or hedge their portfolios. Choosing between covered calls, buying put options, and using VIX ETNs can be a challenge, particularly if markets have already started rolling over. As indicated by both price action and sentiment in news media, we may be in the midst of a correction. See below.

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Cost of Insurance

Before looking at strategies that we can implement on S&P500 or Dow Jones (NYSEARCA:DIA), it is important to note that current levels of implied volatility are low, making portfolio insurance relatively cheap. The density function below uses the adjusted close of the spot VIX for the past ten years.

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Generally speaking, because current implied volatility levels are low, covered calls will tend to generate less premium, put options will tend to be cheaper to buy, ETNs like (NYSEARCA:VXX) are at record lows, and ratio spreads will tend to be less averse to downside volatility risk.

Selling Covered Calls

This is a classic method for making money in a sideways market. Covered calls do not save your portfolio in a meltdown, but they do help during stagnant periods. The idea behind selling the covered call is simple; to sell call options against stock that you own and keep the premium.

Let's assume you own 1000 shares of (NYSEARCA:SPY) and want to hedge all of them with covered calls. To do so, you would sell 10 x July 170 Strike Call options and would generate a $1120 credit. In doing so, you secure yourself a profit (capped at $5,000) if the stock stays above $171.20. In the event that the markets sell off, you keep the $1120 in premium and still are holding the index. See below.

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This type of hedge can be made more aggressive by selling deeper in-the-money calls and by adjusting duration. For example, selling a deep in-the-money call with a month left will be much more sensitive to downward price movement than an identical contract with several months left. One important note to reiterate is that options are not generating much premium since the VIX is so low. As a result, selling a covered call is generally less attractive right now.

Buying Put Options

Put options are powerful because they are extremely sensitive to price changes in the underlying asset. One of the best properties of buying a put option is that the payoff is exponential (because of positive gamma). This is a double-edged sword, because put options can quickly depreciate in value. As a result, minimizing depreciation due to time and volatility are both critical to making the purchase of a put option efficient. Options contracts always become more expensive (in terms of implied volatility) when the markets slip, so it is best to purchase put options before implied volatility has spiked.

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It is almost always advisable to purchase longer durations so that you lose less time premium (theta) and engage in fewer transactions over the lifetime of the hedge. Generally speaking, you do not want to be holding a contract that has less than 60 days until expiration. Individuals that purchase put options on the S&P500 with short durations will find themselves wasting a lot of money. Those who purchase a contract several months out (despite a wider bid/ask) and roll the contract over every 60 days will be much better off than someone purchasing contracts with a month until expiration.

Using VIX ETNs

As stated in the preceding section, when equities sell-off, implied volatility levels explode. Owning a VIX ETN can give you exposure to implied volatility without forcing you to purchase put options on the S&P500. As most VIX followers know, ETNs like (NASDAQ:TVIX) and (NYSEARCA:UVXY) are highly inefficient. It is important not to hold a position in this type of product for too long. See below.

(click to enlarge)For individuals trying to select which ETN to use, it is a no-brainer, use VXX. This is currently the most liquid, most efficient, optionable VIX ETN that tracks short term VIX futures. For those who want to make their hedge less expensive, you can purchase call options on VXX (or the actual VIX). In doing so, you have made a leveraged bet one an extremely volatile underlying asset. In the event of a crisis, this can be an powerful hedge, but because the ETNs are depreciating, it is prone to lose its value quickly. If you decide to buy call options on VXX, be careful, you have both the underlying and the option contract depreciating quickly. It is better to sell puts on VXX than to buy call options, but the payoff typically is less attractive to investors having to post margin.

Ratio Spread

A ratio spread is one of the best ways to hedge a portfolio from losses purely at the cost of margin (depending on the strikes you use) as discussed here. A strategic way to use the ratio spread is to utilize contracts that have 5-7 months of duration and hold them for about 60 days. This gives the holder downside protection and also allows the trader to profit when the spot price slips between the two strikes used in the structure. See the position below.

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Sold 1 x Dec 1650 SPX Put Option @ ---------$80.60

Bought 2 x Dec 1525 SPX Put Options @----- $40.30

Total Cost:--------------------------------- $00.00

The only cost to enter the trade is margin, which is going to be $12,500. In turn, the trade should not erode like a put option in the event of a rally. I advise individuals to open the trade as a single structure rather than trying to trade into it. This ensures that the hedge is truly a hedge and not inherently a gamble.

Conclusion

We have looked at some very basic techniques for hedging a portfolio. Although these techniques are not complex, they can be extremely helpful (or hazardous if used incorrectly). If you have cash to spare, a ratio spread is a great hedge to use right now with implied volatility levels low. If you are looking for a cheap hedge, buying puts on SPY can give you coverage in the event of a downturn. If you want something more conservative, you can always fall back on selling covered calls that are out-of-the-money. Select a strategy that suits your portfolio, risk appetite, and current market conditions. Stay smart and trade safe.

Source: Hedging Risk: It's Better To Be Safe Than Sorry