Trading | March 31, 2020

Spreading Your Hedge: A Strategy for Volatile Markets

Key Points

  • Using options to hedge your portfolio when implied volatility is elevated presents difficulties, but there is still a strategy that can be considered.

  • Effectiveness and cost are the two most important considerations when setting up a hedge.

  • Investors considering any portfolio hedging strategy should have experience using options and should be familiar with the trade-offs they involve.

Hedging strategies are designed to reduce the impact of short-term corrections in asset prices. For example, if you wanted to hedge a long stock position you could buy a put option or establish a collar on that stock.

One challenge is that such strategies work for single stock positions. But what if you’re trying to reduce the risk of an entire portfolio?

A well-diversified portfolio generally includes a variety of stocks. If you wanted to hedge an entire portfolio, you’d have to hedge every position—which could be extremely difficult and costly. To address this problem you could consider buying put options on broad-based indices that closely resemble the makeup of your portfolio, but what if the cost of those puts are exceptionally high due to volatile market conditions? The Cboe Volatility Index (VIX), which measures the relative expensiveness of calls and puts on the S&P 500 index, has recently moved up to levels not seen since the 2008 financial crisis.

Here we’ll look at what adjustments can be made when the cost of hedging is high, with a focus on S&P 500® Index (SPX) put options. It’s important to understand that portfolio hedging is a fairly advanced topic, so investors considering this strategy should have experience using options and be familiar with the trade-offs they involve.

How expensive is hedging right now?

The VIX represents a 30-day forward-looking estimate of market volatility, derived from various option prices on the SPX. Often referred to as the “fear index”, the VIX can be thought of as a measure of how expensive or inexpensive options are on the SPX. When market expectations for volatility (and subsequent demand for protection via puts) are high, this tends to drive up prices on options, which in turn pushes the value of the VIX higher. On March 25th, 2020 the VIX closed at 63.95, after hovering around  15 roughly a month prior.

VIX is at the highest levels since 2008.

Source: StreetSmart Edge®

Generally speaking, this means that the cost of a portfolio hedge using put options on the SPX went up roughly four-fold over one month. For most investors the cost of establishing a hedge at these elevated VIX levels outweighs the potential benefit. So what alternatives do investors have in a high volatility market environment? One solution might be to “spread” off some of the high cost of buying a put option by selling another high cost put option. Specifically, investors who want to establish protection on their portfolio could consider establishing a bear put spread instead of buying a protective put.  (As with any spread strategy, bear put spreads may only be created in a margin account.)

Evaluating a bear put spread for hedging purposes

A bear put spread is established by purchasing a put option and simultaneously selling a lower strike put option on the same underlying with the same expiration date. From a hedging perspective, essentially you are helping offset the cost of a protective put by selling a lower strike put. However, it’s important to be aware of the main trade-off of using a bear put spread over a protective put: the downside protection the spread provides is limited to the difference between the two put strike prices, rather than all the way down to zero.

What is an appropriate expiration date?

Assuming you are considering a portfolio hedge because of heightened near-term uncertainty, you might ask yourself, “How long do I expect the uncertainty to persist?” If you are hedging for a particular event, ask yourself, “When do I expect this event to transpire?” Then select an expiration date that is a little beyond that timeframe in case you underestimate the timing.

How do I select the lower strike on the bear put spread?

This depends on the level of protection that you want to secure. The larger the width (i.e., the distance between the two put strike prices) of the spread, the greater the level of downside protection but also the higher the cost. The smaller the width of the spread, the lower the level of downside protection and the lower the cost. Let’s walk through an example of three potential SPX bear put spreads with different widths using the at-the-money strike price for our long leg to help illustrate the associated trade-offs:

Expiration Date

Long strike (Bought)

Price*

Short Strike (Sold)

Price*

Net

Debit

Protection Level

6/19/20

2475.00

$218.00

2350.00

$170.00

 

$48.00

5%

6/19/20

2475.00

$218.00

2225.00

$132.00

 

$86.00

10%

6/19/20

2475.00

$218.00

2100.00

$100.00

 

$118.00

15%

*as of 3/25/2020 closing price

Assuming you have a portfolio worth approximately $250,000 that is closely correlated to the S&P 500 index, you decide to establish a 1 contract x 1 contract bear put spread. Note: The nominal value of 1 put option on the SPX is equivalent to approximately $247,500 (2,475 x 100 multiplier). Here’s a breakdown of the cost and potential benefit that the spread could provide in the event of a further market downdraft in the coming months.

SPX 2475/2350 bear put spread (5% hedge): The cost of this spread is $4,800 ($218-$170 x 1 contract x 100 multiplier, excluding commissions), or roughly 1.9% of your portfolio. If the SPX closes at or below 2350 at expiration the maximum gain on the spread is $12,500 (2475-2350) or $7,700 when taking the $4,800 cost into account. In other words, you would have paid ~1.9% of the nominal value of your portfolio and achieved a net hedge of +3.08% ($7,700/$250,000), all else being equal.

SPX 2475/2225 bear put spread (10% hedge): The cost of this spread is $8,600 ($218-$132 x 1 contract x 100 multiplier, excluding commissions), or roughly 3.4% of your portfolio. If the SPX closes at or below 2225 at expiration the maximum gain on the spread is $25,000 (2475-2225) or $16,400 when taking the $8,600 cost into account. In other words, you would have paid ~3.4% of the nominal value of your portfolio and achieved a net hedge of +6.56% ($16,400/$250,000), all else being equal.

SPX 2475/2100 bear put spread (15% hedge): The cost of this spread is $11,800 ($218-$100 x 1 contract x 100 multiplier, excluding commissions), or roughly 4.7% of your portfolio. If the SPX closes at or below 2100 at expiration the maximum gain on the spread is $37,500 (2475-2100) or $25,700 when taking the $11,800 cost into account. In other words, you would have paid ~4.7% of the nominal value of your portfolio and achieved a net hedge of +10.28% ($25,700/$250,000), all else being equal.

Candlestick chart illustrates breakdown of the cost and potential benefit that the spread could provide in the event of a further market downdraft in the coming months, as explained in prior text.

Source: StreetSmart Edge®


Is it worth it?

The hedging strategy presented above provides one method of curbing losses in the event of a further market downturn, but is the cost worth the benefit? It really depends on your individual desire for protection and individual risk tolerance. In the example above, if the SPX closes above 2,475 at expiration, you will lose what you paid to establish the hedge. However, if the S&P continues to drop in the coming months, then the hedge has the potential to help cushion some of the blow. If you are looking to put on some protection in a high volatility market environment, this hedging strategy could prove useful.