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Hedging with options
As of this writing in mid-June 2022, the S&P 500 is down 19% YTD and looks set to re-enter a “bear market” this coming week. The tech-heavy Nasdaq is down 28% YTD, with many smaller-cap tech names, many of them loss-making hyper-growth counters down in excess of 50% from their peak prices.
Many, millennials and Gen X/Ys who started investing/trading these couple of years amid all the hype surrounding meme stocks and hyper-growth counters will be facing their very first “bear market” test. When “shit” hits the fence, we come to the realization that the market isn’t all just a bed of roses. However, amid all the doom and gloom, is there a way to help protect your portfolio against a market decline like what we are currently witnessing?
Back in July 2020, I wrote this article: How to hedge stocks. 5 levels of hedging. In that article, I explore various ways of protecting your portfolio, from the easiest way which is to simply keep cash to more advanced methods such as using leveraged inverse ETFs.
One of the hedging strategies involved using options (level 4 of hedging). This is not an intuitive method for most people, given that the usage of options is still often seen as a “black box”. However, in my frank opinion, options should be seen as a quintessential tool as part of your trading arsenal and not something to be feared of.
With the right knowledge, options can be extremely flexible, with one of its key valued functions as a hedging mechanism.
In this article, I will go slightly in-depth as to how hedging with options can be done to protect part of your portfolio. This might be of interest to NAOF readers amid the current volatile stock market climate.
Hedging is for protection, not speculation
Hedging strategies are used by investors to reduce their exposure to risk, if an asset such as stocks, in their portfolio is subject to a sudden price drop.
Hedging should not be seen and used as a speculative tool, although the temptation is always there. Look at how Bill Ackman spectacularly made $2.6bn from his hedges vs. his $27m cost of buying that insurance. That is a payout of 100x!
I am not saying that Bill Ackman is a huge speculator here but such reports tend to “dramatize” the allure of hedging, encouraging people to go crazy buying protection, not as a means to protect part of their portfolio but to try and “time” and profit off a huge market correction.
I have been guilty of that in the past.
As Peter Lynch, the famous ex-fund manager of Fidelity once said:
“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves”.
Peter Lynch doesn’t say investment portfolios won’t lose value during corrections and bear markets. Sure they do. However, investors that are focused on anticipating a bear market more so than on having a sound portfolio with a solid long-term investment plan tend to lose more money buying too much protection than is needed.
Hedging when done right, reduces uncertainty and limits losses without significantly reducing the potential rate of return of your portfolio. That should be the aim. When used strategically, derivatives such as options can limit investors’ portfolio losses in a bear market.
A put option on a stock or index is a classic hedging instrument that can be used for portfolio protection.
Before I go into more details as to how I use Put options to hedge against downside risk, let me first briefly touch on how Put Options work.
Additional Reading: 3 Safe Option Strategies better than stock buying
How Put Options work
Put Options give the BUYER the right to SELL an asset at a specified price (strike price) within a predetermined time frame (contract horizon).
Take, for example, Peter bought Stock ABC (a biopharma stock) for $20/share, believing that the price of this stock will go up. However, he is also concerned that Stock ABC might witness a huge correction, given how notoriously volatile biopharma stocks can be.
He decides to buy a Put Option with a strike of $18, paying $3/share in premium, with the contract duration effective for 1-year.
During the 1-year horizon, if the price of Stock ABC goes up to $25/share, Peter will NOT have the incentive to exercise his right to Sell Stock ABC at $15/share. No one in their right frame of mind will do that.
He decides to let his Put Option “lapse” or expire out of the money. He thus “foregoes” the $3 in premium he paid, but more than compensated that from the rise in Stock ABC.
However, if during the 1-year horizon, the value of Stock ABC drops from its original cost of $20/share to $10/share, Peter now has the incentive to exercise his right to Sell Stock ABC at $18/share.
Instead of losing -$10 from his investment in Stock ABC ($20 cost – $10 current value), Peter has mitigated his losses to just -$5 (-$10 from stock ownership, but offset by profits from his Put Option of +$5, calculated as $18 strike price – $10 current price + $3 premium paid)
By purchasing a put option, Peter is transferring the downside risk to the seller. In general, the more downside risk Peter (the buyer) seeks to transfer to the seller, the more expensive the hedge will be.
This means that a higher strike of $20 (downside protection from this price onwards) with the same contract horizon will cost more than the $3/share in premium which Peter paid to seek downside protection from a strike of $18.
Similarly, the longer the contract duration, the more expensive Peter will have to pay for the “insurance” protection.
Let’s talk about this in the next segment.
Consider Expiration Date and Strike Price
Once an investor has determined which stock (stock with weak momentum perhaps or one which is fundamentally weak) or index they like to purchase a Put Option as a hedge, there are 2 key considerations:
- Days to Expiration (DTE) or simply the contract horizon
- The strike price (at which level they wish to start their downside protection). In Peter’s example, that price is $18/share. At any price below $18/share, Peter has the incentive to exercise his right to Sell Stock ABC at a higher price of $18.
When it comes to Put Options purchase as a hedge, I typically will select a long days-to-expiration (DTE) contract (typically 1 year and more) and select a Put Option strike that is out-of-the-money (OTM).
The key rationale is that such an option contract is relatively “inexpensive”.
Long Expiration Date
Let’s take for example the available Put Options on the SPDR S&P 500 ETF, one of the most liquid and widely traded ETFs in the world, whose performance looks to replicate that of the US S&P 500 index.
Say, David, whose portfolio consists of mainly US stocks, might wish to buy some protection to hedge against the downside movement of US stocks.
The current price of SPY is $376.23
Using the same strike price, the table below shows the cost of the different Put Options based on the different expiration periods.
There are several observations from the table above.
The cost of buying Put Options (at the same strike price) is not proportionate to the days to expiration. In laymen’s terms, the cost of buying a Put Options contract with 165 days to expiration is NOT 3X the cost of buying a Put Options contract with 46 days to expiration.
While the Put Option cost is higher as the contract horizon increases (need to pay more for additional time for the price to potentially move in your favor), the cost/day drops as you extend the horizon.
The most “expensive” option (718 days to expiration costing $59.68/share) provides an investor with the least expensive protection per day.
This also means that put options can be extended very cost-effectively. If an investor has a 6-month put option on a security or index with a determined strike price, it can be “rolled” by selling off the original contract and replacing it with another contract with a suitably long horizon as well.
Typically, I will buy a long DTE Put Option with at least 1-year to expiration and when the remaining DTE falls to 3 months, I will look to either 1. Close off the contract and take my profits/losses or 2. Roll the contract to further extend the contract horizon.
By rolling a put option forward, I can potentially maintain a hedge for many years.
Strike Price
When it comes to the selection of the right strike price to purchase my put options, I will typically buy an out-of-the-money Put Option.
An OTM Put Option is when the strike price is BELOW the current market price.
Say, for example, the current price is $20 and I purchase a Put Option with a strike price of $18. This option is OTM.
Only if the share price drops below $18 will I (as the Put option buyer) have the incentive to exercise my right to sell my shares at $15 (when the market price is below that).
The reason for buying OTM options is that they are less expensive. A Put option with a strike of $18 will be less expensive than a Put option with a strike of $20 and that Put option with a strike of $20 will be less expensive than a Put option with a strike of $25.
However, the price of the stock needs to move from $20 to below $18 (a $2 price drop) before it makes sense for me to exercise my $18 Put option whereas for the $20 Put option, that decline only needs to be $0.01/share.
Nutshell, the more expensive the premium is, aka, the higher the stock price, the greater the probability of you potentially profiting from it.
The key question then is: What is the right balance between NOT over-paying for a Put option while yet balancing the potential profitability of the trade.
I like to purchase Long-Dated (first point) OTM Put Options with a DELTA (which measures the sensitivity of the option price movement relative to the underlying price movement) of around 0.3-0.4.
The nature of these Put Options serves as a good hedging instrument in my opinion.
They are not overly expensive, nor are they extremely cheap which consequently reduces the effectiveness of the hedge.
As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per day can be low. Although they are the “most expensive” in terms of the initial outlay, they are effectively the cheapest when you view the cost on a per-day basis. However, do note that this is not the only way to structure an option hedge for your portfolio.
Additional Reading: 4 Option Trading Strategies for Beginners
Hedging with options: Use as part of a diversified portfolio
Hedging strategies should always be combined with other portfolio management techniques like asset class diversification and periodic portfolio rebalancing.
A well-diversified portfolio (across different asset classes with low correlation) will ensure that one sleeps well at night.
Take for example a $100,000 portfolio that has a 60% exposure to equity and 40% exposure to bonds. In a significant market bear market correction, say equity drawdown of 30%, the equity value will decline from $60,000 to $42,000.
Assume that the value of the bonds appreciates by 5% in this scenario, from $40,000 to $42,000.
Total portfolio value = $84,000 or a decline of 16%.
If the original equity portion ($60,000) is 30% ($18,000 exposure) hedged through “cheap” long-dated OTM put options, the hedge ($18,000 worth) value will now be (1.3*$18,000 = $23,400), translating to a profit of $5,400 which will help to partially mitigate the portfolio loss.
Total portfolio value + hedges = $84,000 + $5,400 = $89,400
Portfolio value decline = slightly north of 10% in a 30% bear market
While the overall hedged portfolio still loses money in a bear market, the 10% decline in portfolio value is not as significant as the 30% decline in a 100% equity portfolio or the 16% decline in the balanced portfolio (60% equity, 40% bond).
Additional Reading: Sell Puts to win in any scenario
Conclusion
It is always prudent to take some of your profits to purchase “cheap” Put Options as insurance against a sudden and swift market downturn.
I typically look to hedge 30-40% of the equity portion of my portfolio through long-dated OTM put options. I will periodically monitor my exposure and look to trim/add more put option contracts and close/roll them as and when necessary.
Long-dated options might seem expensive on an upfront cost basis (all else constant) but they are much cheaper when the cost is viewed on a per-day basis. This cost can be further reduced by purchasing OTM options. I tend to select OTM options with a delta of around 0.3-0.4 as my ideal strike prices.
This is my personal preference and is by no means the RIGHT or ONLY way of hedging using Put options. Some would prefer to select shorter-term time horizons to be both “opportunistic as well as disciplined” in taking profits from your hedges or to adjust the strike prices periodically. This can also be a viable way to hedge. In this case, I will prefer to structure a Put Debit Spread.
At the end of the day, hedging using options should not be seen as a speculative way to profit “big-time” from a potential bear market but as a useful means to help mitigate your portfolio losses.
