Market action in the Fall of 2008 was a painful time for the average retail investor armed with only stocks, bonds, mutual funds and money market funds. It's amazing that there are different types of barriers to using a basic protective put strategy. While the public can suffer the consequences of institutional derivative holdings (sans the bonuses when all is back to normal), it appears having option basics discussed as part of mainstream investing is years or decades away. That's when I think about how much I like Optionetics.

Since I'm working on this at night, I need to cut the editorial there so the increase in blood pressure doesn't keep me awake. But hopefully it emphasizes the power of a simple tool you have in your arsenal for managing risk. As the markets move back upward, don't lose the commitment to identify a mechanism to protect longer-term holdings. A system of hedging with puts is one great alternative.

Hedging

Put options can be used to partially or completely hedge a specific position or to partially hedge a portfolio. Although there are more precise delta neutral strategies available to traders, this article focuses on portfolio oriented approaches that are used for specific market conditions to minimize longer-term costs. They are geared towards periodic reviews rather than active daily management.

A moving average is one technical indicator an investor can use as a basic filter to identify periods when hedging is appropriate. Bullish, bearish and neutral periods can be designated by noting the level of a specific index relative to its 50-day and 200-day exponential moving averages [EMAs]. Using these three inputs:

• When the index is above both EMAs conditions are bullish,
• When the index is below both EMAs conditions are bearish, and
• When the index is between the two EMAs conditions are neutral.

The trader may choose to hedge when conditions are neutral or bearish, or only when they are bearish. To help minimize whipsaws - trading in and out of a position when the index level is close to the EMAs - the investor can identify a specific review period such as the week after expiration or the end of the month.
Example

Looking at the equities portion of the sample portfolio provided last week, exchange-traded funds [ETFs] are identified as potential holdings that will simulate the allocations. In addition to checking the weekly correlation to the target index, the weekly correlation to S&P 500 Index (SPX) is also provided in Table 1.

Note the limits to equity diversification - there is still a strong relationship between movement in SPX and the other index proxies. In other words, the risk is only partially reduced from the equities allocation provided. Also note that it is not uncommon for strong market declines to strengthen the relationship across equities - so strong bearish moves may be felt more broadly across different equity classifications.

Because it never gets old, the portfolio provided and allocation ranges are for sample purposes only and do not represent a recommended portfolio. You need to consider your individual constraints and preferences when constructing investment allocations.

Table 1: Equity Allocation and ETF Proxies

A trader can hedge each equity allocation separately using the corresponding ETF puts or they can consider using SPY puts only for a hedge that is less exact and also a lot less costly. Liquidity in SPY options provides much tighter spreads which reduces the cost of individual options. In addition, more strike prices are likely available providing flexibility in your hedge. Finally, using puts for one underlying versus three will save on commissions as well.

SPY Put Approach

Assuming a $100,000 portfolio with the allocations identified in Table 1 for each ETF, the total equity investment is $35,000. At month end SPY, IOO and IWM are all below their 50-day & 200-day EMAs, prompting a partial hedge using SPY puts. With SPY at $82.83 and implied volatility relatively high, Table 2 lists the put options considered using Platinum. Once again the decision regarding how much protection is right is a personal one. The investor wants to go far enough out in time to minimize the impact of time decay, but also must consider the relative implied volatility [IV].

The impact of time decay also creates an argument to review a portfolio after options expiration rather than at month end. Again, it's a personal choice, but it may make option selection and rolling out a hedge easier. In the scenario provided the investor can use options with 77 days to expiration or 140 days to expiration in a high IV environment. The main concern is that within one month the shorter-term hedge will have 47 days to expiration and run into significant time decay issues if not rolled out. Reviewing the hedge after expiration will move it towards the 30 day window when a hedge decision must be made again.

Figure 1: SPY Put Options with 77 Days to Expiration

At $35,000 and protection beyond an 8% move downward, the investor is allowing a $2,800 loss. This translates to a $6.63 downward move in SPY to approximately $76.20. While the equities portion of the portfolio is not completely in SPY, this assumption is made to identify the number of puts used for the hedge. In this case the portfolio is similar to 423 shares of SPY (35,000 divided by 82.83).

Assuming the investor wants to use the Apr 76 puts with a delta of -30.58, 13 puts can be purchased at $3.75 (423/30.58). The hedge costs $4,875 and has a delta of -398. At the end of the next month, SPY is trading below the EMAs at $73.93 and the puts close at $5.80. This translates to a loss of $3,765 for the ETF portfolio and a gain of $2,665 for the puts, for a net loss of $1,100 which is within the investor's risk tolerance.

The downside to the end of month approach is that the investor must now create another hedge in an IV environment that is even higher. Using a similar timeframe and loss protection approach, another puts purchased at $3.60 are worth $1.25 the following month after an SPY rally to $79.52. The portfolio gains $2,365, but the options lose $3,055 for a net loss of $690.

Over the two-month period losses were contained within the maximum amount, but hedging does come at a cost. Rather than a $1,400 loss without hedging, the investor realized a $1,790 loss. The period covered was late Jan 2009 through late Mar 2009 which includes particularly strong downward and upward moves. It realistically highlights the psychology side of investment when faced with a decision in late March to hedge or not hedge. SPY closed March above its 50-day EMA, but below its 200-day EMA - the neutral area. Without any specific rules for this region, it would probably be difficult to for someone to place a new hedge.

The example illustrates that dampened portfolio gains must be acknowledged in advance when hedging and why a systematic approach should be back-tested to provide realistic results the individual can consider as part of their investment approach. Different filters may be selected or option selection changed.

The example provided is not an argument against the use of hedging. The same approach would have yielded results in the fall of 2008 that would be appealing to most investors: two month gains of more than 30% from late Aug to late Oct using the same number of SPY shares. It's intended to highlight the impact of hedging when strong movements occur in both directions and implied volatility impacts those results. During more calm periods, the investor may focus on deltas rather than moves in the underlying. Regardless of how the hedge is selected, the example is an argument for mapping out the approach in advance so you can stick to the plan as required and have a realistic sense of expected returns.

Vive le Tour.

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

Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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