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The decision to hedge a portfolio with options leads to a series of additional decision making, which may not be ideal right when the markets become volatile. By mapping out guidelines that make hedging more systematic during the investment process, the individual can manage risk while still benefiting from the general tendency of the markets to move upward. Since everyone’s constraints and preferences vary, keep in mind the sample portfolio and hedging techniques described here are for illustration purposes only.  

Portfolio Decisions

Assume an investment portfolio uses exchange-traded funds [ETFs] to access different asset classes for diversification purposes. With portfolio hedging anticipated, ETFs are checked to see if options are available. ETF correlations versus the target assets are also checked to confirm they serve as reasonable proxies. Risk-adverse investors may prioritize the availability of liquid options for a specific ETF over one that is better correlated to the target market. This is one decision that needs to be made earlier in the investment process.

In addition to checking the ETF versus target asset correlation, the investor also needs to check correlations within the portfolio to confirm diversification is achieved. Correlation analysis brings up a second decision early in the process; whether to use ETFs that better suit diversification goals (correlations) are those with longer histories. New ETFs are being introduced all the time so a balance between the two (correlation and history) may need to be struck.

Going back to the well diversified portfolio, assume a $50,000 portfolio uses the following allocation targets and ETFs to serve as the base portfolio. The data is valid for the close on Mar 5, 2008:

Index and ETF correlations were calculated using data downloaded from Worden’s TeleChart. SHY reflects a negative correlation because it a bond fund that is being compared to a bond yield index. So in this case, we’re looking at an ETF that does have a positive correlation to the target asset. Using 0.70 as a lower limit to identify a positive correlation, it appears the ETF proxies can be used. 0.80 should be used if a strong positive correlation is required.

The portfolio correlations are more important than the proxy correlations if seeking diversification. A correlation matrix for the four securities appears below:

Adding the commodity and bond ETFs does a good job of diversifying the equity portfolio—GSG has an extremely weak negative to no correlation with them, while SHY is uncorrelated.

Hedging Decisions

The next consideration includes what ETFs to hedge and when with put options. The amount of time used for the hedge (option expiration) depends on a few different factors all stemming around long-term cost if the investor wishes to hold hedges on a regular basis. However, since long investments are generally held when the individual is bullish, protection becomes less effective as time progresses and the value of the investment increases.

Time to expiration is not the only cost an investor should consider for the puts. Both commissions and slippage (bid-ask spread) will more heavily impact the overall cost if short-term protection is used. Balancing these three considerations:

1. cost of time
2. commission
3. slippage

Different puts can be evaluated. In this article, SPY puts are also used for EFA hedging since the ETF is well correlated to SPY. This reduces the overall commission and reduces the impact from the bid-ask spread. This can be verified by comparing the at-the-money (ATM), next month put options for each ETF:

If the equity positions are held for 12 months and next month put options are used to protect the ETFs on six occasions, the difference in spreads will erode long-term profits. Similarly, consider the impact from additional commissions.

A non-traditional way to add EFA into the SPY put hedge is by using the SPY-EFA correlation value to identify EFA deltas (100) in terms of SPY deltas (55 deltas = 0.79 x 70). This results in a hedge based on an initial SPY delta of 165 (110 deltas + 55 deltas). The historic volatility of EFA will also impact the success of such an approach.

Three puts with varying times to expiration are identified below as hedge candidates. The most liquid SPY options are relatively shorter term and partially protect the biggest portion of the portfolio (approximately $20,000 or 40%). The delta for the out-of-the-money [OTM] combined puts is approximately -178 versus a delta of +155 for SPY and EFA.

Expiration dates for the GSG and SHY puts are further out reflecting the increased cost associated with transactions for these options (primarily slippage). In all cases, implied volatility [IV] is high relative to historical volatility [HV] using HV calculation values that are closest to days to expiration. Collectively, the hedges represent 5.4% of the portfolio. Both the SPY and GSG puts represent large percentages of the position being hedged, however, the GSG hedge will likely be in place for a longer period of time.

The portfolio will be monitored over the next four week without adjustment. Part two of the article will appear in April with comments on portfolio results and additional considerations for hedging.

To access other articles written by Clare White, please click here.

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
Questions for Clare? Visit the Optionetics.com Discussion Board

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