Feed Your Hedge Against Volatile Markets

Traders behaved cautiously Tuesday, to say the least, as they suffered through the post-Alcoa (AA), poor-home-sales hangover ahead of the Federal Reserve’s release of the minutes from the FOMC’s March 18 policy meeting. Yet implied volatility, in VIX terms, is up less than 2 percent.

The VIX may be saying that a lot of people think the credit crisis is over and the recession is baked into current market prices, but there are plenty of reasons to remain cautious. Current low volatility is giving option buyers an opportunity to hedge their core long positions with puts.

Assuming we’re long anything at this point, what puts would we use as a hedge, and how many do we need? First, we have to figure out how our portfolio moves in relation to the market. We know that four out of five stocks move in the same direction as the market trend, but by how much? Two numbers can give us a pretty good idea: beta and R-squared.

Beta measures how a stock’s volatility compares to the overall market. Beta greater than 1 indicates higher volatility - i.e., wider swings - and beta less than 1 means the equity is more lethargic. R-squared tells how consistently a stock tracks market movement; the higher the R-squared value, the more likely the stock is to move with the market at any given time.

Okay, by now you’re thinking, "What, so now I have to be a statistician?" Not unless you get a thrill out of doing overly precise calculations in a futile effort to match reality with theoretical averages. The fact is, beta and R-squared are historical numbers that just give us an idea of how an equity tends to behave. So to determine what our hedge position should be, we’re going to simplify things and ignore R-squared (that is, assume a value of 1, or 100%).

So first, we want to calculate our beta-weighted portfolio value, by multiplying the value of our holdings in each position by the beta of the stock or fund and adding it all up. Say we have three stocks: AAA has a beta of 0.93; BBB is a utility, with beta down at 0.40; and ZZZZ, a volatile tech stock, is characterized by a beta of 2.18. Here’s the calculation, based on the hypothetical holdings shown:

This means that our risk is about equal to having $36,841 invested in “the market.”

Now we have to choose a proxy for the market. We need an index-based vehicle that is broad and has easily traded options. SPDR S&P 500 (SPY) is the obvious choice, although one might want to use NASDAQ 100 Trust Shares (QQQQ) for a portfolio that’s dominated by NASDAQ stocks, or iShares Russell 2000 Index (IWM) for a small-cap portfolio. But for our example, we’ll use SPY.

With SPY trading at around $136.50 per share, our beta-weighted portfolio value is approximately equivalent to holding 270 shares of SPY ($36,841/$136.50); therefore, to adequately hedge this portfolio, we would need to buy 3 put contracts on SPY. Because time is our enemy here, we want to minimize time decay by going as far out as is practical. The December 2010 expiration seems a bit excessive, in terms of both time and money; December 2009 looks about right for riding out this bear market with minimal time decay, and if need be, we could always roll out come the fourth quarter of 2009.

Now for the strike price. Because we’re hedging against a major decline, we don’t need to spend the extra 20-some percent to go at the money. At about $10.25 per share, the 123 strike (10% out of the money) is a lot more attractive, but since the S&P 500 has already seen a 20% decline from top to recent bottom, the market may have only another 10% to fall. The 129 strike, at just over 5% out of the money, looks like a good compromise. SPY DEC09 129 puts are trading at around $12.35.

If you think it’s excessive to spend $3,700 (3 × the $1,235 price of each put) to protect a $40,000 portfolio, think of it as homeowners insurance. Your portfolio is a valuable asset that could be wiped out if some kind of financial disaster happens, leaving your retirement in jeopardy. The difference between options and insurance, though, is that you’re likely to get some of your premium back if you decide to sell the policy before it expires.

Another difference is that you can sell premium - by selling calls against your holdings - to pay for the premium that’s trickling away over time. So in the end, you’re going to spend much less for this insurance than it first appears.

So, if your investment strategy includes holding a core portfolio of long positions through good times and bad, but you’re concerned that there might be another shoe to drop (and this bubble-driven market seems to have more shoes than a centipede), now might be a good time so consider setting up a hedge position, while implied volatility is low. If another sell-off, accompanied by higher volatility, comes, those $12.35 puts are going to look cheap.

Comments

[granger]

Good example. Thank you. Is there a resaon to use options on the SPY or just buy puts right on the SPX?

[Augustus]

Spending about 10% to insure that the future loss will be no more than an additional 5% seems a bit expensive to me. It would require that you have a belief that your portfolio will outperform quite a bit to the upside. The upside gains that greatly outperform will allow you to pay the premium and still beat the market on that upside move. Suppose that I have a strategy that will return 40% in the backtest. Then I can sacrafice the 10% premium and still make handsome gains. And the premium will allow me to crawl through the down turn without facing a wipeout from strategy volitility. However, if I only expect market returns plus a slight bit, I'm not sure that the portfolio can absorb a lot of insurance charges and still amke any money.

I've been trying the "option put insurance" approach since last Sept. when I bought some Jan '09 Puts on the QQQQ. The puts are profitable, but they haven't really done the job for me. I would advise others to look at the IWM puts. Some of the Naz 100 stocks can take on a life of their own and cause that indes to trade a lot differently from the rest of the market. Think GOOG, AMZN, AAPL, RIMM.

My original idea was to go about as far out as possible, and then roll the puts with about six months remaining. Attempting to avoid the worst of the time decay in the last months of the option's life. As my portfolio gained in value last fall, for each $10,000 increase in value I bought $500 more in Puts, using the same strike contract that I originally chose. That gave me some Puts at a much cheaper price as they were getting pretty far OTM. Another benefit of that is that when there was a downturn, the Gamma was working for me. I also was trying to reduce the trading costs a bit, anticipating the roll at some future date with one trade instead of lots of different strikes to liquidate.

The insurance factor is really easier to write about and discuss than it is to implement. I'm not really knocking the article as it makes some good points. However, the insurance might not quite be what you have hoped for.

[koko]

yet, another great article! a quesion: in the example above, at what price would you sell the covered calls to offset the price of the insurance, and how far in the future?

[bruin532]

Thanks goodness everyone finally is bearish read all the Alpha blogs now and there all calling for the worst case its finally time to buy when everyone is going one way go the other the Armstrong business cycle called it!

[CondorOptions]

@granger: we've written about that topic here: www.condoroptions.com/.../

@Augustus: thanks for your response. To your point about hedging with different indexes, note that in the article we're just suggesting hedging with QQQQs for portfolios that are heavy in other Nasdaq names; certainly a small cap-heavy portfolio should use IWM instead.

@koko: you can sell calls every month; it's better to choose strikes using implied volatility and delta readings, rather than choosing them by price.