Personal Finances for 2008: Considerations for Portfolio Hedges
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When your investment plan includes hedging a diversified portfolio with options, different issues come to the surface when implementing the plan. First, since the portfolio is diversified you’ll likely encounter varying historical volatilities for the underlying securities. You may also encounter a broad liquidity range for the available options. Both of these issues will impact the length of time selected for the hedge, as well as the type of hedge you select (perfect or partial). A final consideration is how frequently you’ll evaluate the hedge and how you will go about bringing the position(s) back to neutral.
Relative Volatility
When selecting the options you will use to hedge a position, consider the long-term historical volatility [HV] of the underlying to help determine the type of hedge to establish (perfect or partial). SHY, the iShares Lehman 1-3 Year Treasury Bond exchange traded fund [ETF] has a 100-day HV of 2.91 with a more volatile 6-day HV of 3.35. Short-term implied volatilities [IV] using the ask price for near month and next month options range from 4.05 to 36.05 while longer-term IVs range from 3.72 to 12.58.
When selecting a hedge for a very low HV position with relatively high IVs, you probably want to be a little less mechanical in terms of targeting a neutral delta value. You may want to consider the maximum risk you’re willing to accept for the overall position and evaluate longer-term puts that can reasonably satisfy that maximum risk.
Liquidity
Option liquidity impacts the bid-ask spread and the slippage costs for hedges. You may want to consider options with more time to expiration to minimize the on-going cost of slippage. The downside to such an approach is the put used may become increasingly out of the money as time progresses. As delta move towards 0 for such an option, you would need to purchase an increasing number of such puts to bring the position closer to delta neutral. This can exacerbate slippage costs.
When hedging an underlying with less liquid options, frequent buys and sells or purchasing a large number of options leads to higher costs that can be completely lost in the bid-ask spread. If you have the time, consider calculating a longer-term correlation of returns for the whole portfolio against a very liquid broad-based index ETF. Depending on the extent of diversification in your portfolio, it may make sense to use two or three ETF options that are well correlated to portions of the portfolio.
Schedule & Availability
The hedging approach you want to use may not be realistic just given the time you have available on a regular basis. Be sure to consider this when mapping out your investment plan and recognize the time you have when you’re focused on planning may not be representative of the rest of the weeks or months in the year.
Hedge Results
A sample hedge was initiated in early March and managed on a weekly basis using Friday closing values. In late March the SPY-EFA hedge was adjusted using June puts in place of April puts due to expire in three weeks. The weekly portfolio values for the hedged and unhedged portfolio appear below:
Date | 3-28* | 4-4 | 4-11 | 4-18 | 4-25 | 5-2 |
Hedged | 52,150 | 51,300 | 51,985 | 51,416 | 50,549 | 50,047 |
Unhedged | 49,605 | 50,565 | 50,270 | 51,399 | 51,539 | 51,555 |
Difference | ($2,545) | ($735) | ($1,715) | ($17) | $990 | $1,508 |
* Initiated new hedge selling Apr 128 SPY puts and buying 125 Jun SPY puts.
The standard deviation of returns for the hedged portfolio is slightly less than the unhedged portfolio over this period, which included a 7.5% rise in the S&P 500 Index.
As with any investment decision, the manner in which you elect to hedge a portfolio is a personal one based on your individual constraints and preferences. These include quantitative (time available) and qualitative (risk aversion) measures that will impact your hedging decisions. To help gauge how effective an approach is, consider using the Optionetics Platinum application to see how that approach would have worked in the past.
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Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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