Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
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Investing with Options: Hedging your Portfolio
Koen Hoorelbeke
Investment and Options Strategist
Summary: As the market is in a remarkable rally, this article emphasizes the importance of hedging strategies in protecting portfolios from potential market downturns. Despite current bullish sentiment, it reminds investors to be cautious and prepared for any market reversal. The piece explores various hedging tools like purchasing out-of-the-money put options on indices and VIX call options. Examples are provided to explain how these strategies can offset losses in the event of a market decline.
In the face of extraordinary bullish sentiment, the market has been on an impressive rally since the start of the year. The sensation of fear seems obsolete, replaced by an almost euphoric belief that the trajectory is ever upward. Yet, it is precisely within these moments of unyielding optimism where the exercise of caution becomes paramount. Echoing the timeless wisdom of Warren Buffett, 'Be fearful when others are greedy,' it might be the opportune moment to shift our focus towards risk mitigation strategies. In this article, we explore various hedging mechanisms designed to shield our portfolios from potential market downturns.
Hedging, as per finance terminology, involves taking an offsetting position in an asset or investment to mitigate the price risk of an existing position. In essence, a hedge is a trade enacted to counteract the risk of adverse price movements in another asset. Normally, this entails taking a contrary position in a related or derivative security based on the asset intended for hedging.
So, are we discussing diversification? Not quite. A truly well-diversified portfolio has a built-in risk distribution across various asset classes, sectors, and geographies, reducing the need for protection against market downturns. Diversification ensures a state of equilibrium. In contrast, hedging serves as a shield against black-swan events or occurrences that can significantly imbalance your portfolio, such as market crashes or major disruptive news events.
Let's put this into a real-world context. Suppose you began trading on January 3rd this year, and by some stroke of fortune, you put all your capital into a handful of AI-related stocks with a bullish bias (a highly undiversified and unprotected composition). Your portfolio has more than doubled since then, and you're envisioning your millionaire status by year-end.
However, the market operates on its own terms, and the current surge signifies an overbought condition, priming the market for a correction or a potential downturn. The timing remains uncertain. It could be imminent or might be months away. But the scenario underscores the importance of setting up a hedge in anticipation of market reversals.
Timely implementation of a hedge is crucial for its effectiveness. Contemplating this protection before the market turns against you ensures you reap its benefits. Waiting until an adverse event unfolds often means acquiring the hedge at a much higher price, rendering it an expensive, less effective shield. In other words, late action compromises the hedge's protective quality.
So, what tools are available to set up this essential protection?
1. Options on Indices: Purchasing out-of-the-money (OTM) put options on an index such as the S&P 500 can safeguard against broad market downturns. These options appreciate in value when the market tumbles, offsetting your portfolio's losses. They are typically cheaper when market volatility is low.
2. VIX Options: The VIX or volatility index frequently spikes when the market dips. Purchasing VIX call options can serve as a hedge against market downturns, as these options gain value when volatility escalates.
3. Precious Metals: Gold and silver commodities, historically used as inflation and market uncertainty hedges, could be part of your strategy. You might consider buying options on ETFs tracking these commodities, or directly invest in the commodities themselves.
4. Currency Hedging: If your portfolio significantly exposes you to foreign investments, currency risk becomes a potential concern. Options or futures on currency pairs can hedge against unfavorable exchange rate movements.
5. Inverse ETFs: These funds are designed to perform inversely to a specific index or benchmark. If your portfolio is long on tech stocks, hedging with an inverse ETF appreciating when tech stocks decline could be an effective strategy.
Now let's have a look at what all this means with some real-world examples.
Important note: the strategies and examples provided in this article are purely for educational purposes. They are intended to assist in shaping your thought process and should not be replicated or implemented without careful consideration. Every investor or trader must conduct their own due diligence and take into account their unique financial situation, risk tolerance, and investment objectives before making any decisions. Remember, investing in the stock market carries risk, and it's crucial to make informed decisions.
1. Options on Indices:
When it comes to hedging strategies, options on indices hold a unique position. These instruments allow investors to directly hedge against broad market movements. Instead of having to deal with individual stocks, an investor can buy Put options on an index such as the S&P 500 to protect their portfolio from large-scale market declines. This is especially valuable during times of economic uncertainty or market volatility, when broad market movements can have significant impact on a portfolio. Simply put, if the market falls, the value of these put options will rise, thus offsetting losses in your portfolio. As we venture into our example, it's essential to note that the timing, strike price selection, and management of these options play a crucial role in the effectiveness of this hedging strategy.
This trade setup involves purchasing a long-dated SPX Put option with a strike price of 4450, expiring on December 15, 2023. Here's an analysis of this trade:
1. Strategy: This is a protective put strategy, a form of hedging where an investor buys a put option to guard against potential losses in the underlying asset, in this case, the S&P 500 index.
2. Trade Setup: You are buying an out-of-the-money put option (current SPX level assumed to be higher than 4450). The further the index falls, the more intrinsic value the put option will accumulate.
3. Premium and Risk: The net debit of 87.70 is your maximum risk per option contract (ignoring trading and transaction costs). This translates to $8,770 in total risk for one contract as SPX options have a contract multiplier of 100.
4. Breakeven Point: Your breakeven point at expiration is the strike price minus the premium paid, or 4450 - 87.7 = 4362.3.
5. Days to Expiration (DTE): With approx. 140 days till expiration, the market has ample time to make a downward move.
8. Delta and Theta: The delta of -0.3238 suggests a 32.38% change in option's price for every 1-point move in the index. It's a measure of the option's sensitivity. Since you're long the option, theta (time decay) will work against you.
Now what could this setup mean for you? How could it help protect your portfolio? Let's assume the market does drop in the coming months to a level of around 4320, which is a support area for the SPX.
Using an options calculator (of which there are many on the internet, I'm using the one found at barchart.com, but there are many more), we calculated that, with a drop in the underlying SPX to 4320, an increase in volatility to 20% (a plausible assumption during a market downturn), and a decrease in the days till expiration to 30 days (randomly picked), the theoretical price of your put option could increase to approximately 164.78. Remember, in this example, we bought it for 87.70.
This is an increase from the initial cost of 87.70, providing a substantial profit on the option that can help offset any portfolio losses caused by the market downturn.
Also, we note that the option's Delta has changed to -0.66, implying that for every point drop in the SPX, the price of your option could increase by roughly $66.
Furthermore, the option's Vega of 4.54 indicates that a 1% increase in implied volatility can increase the option price by approximately $4.54. This is particularly beneficial during market downturns, when volatility tends to rise, enhancing the value of your protective put option.
If, on the contrary, the SPX remains above the strike price, the premium you paid for the option (87.70) would be forfeited.
When contemplating the cost of the option, you must consider its proportion to your portfolio. If the hedge's total cost, in this case $8770, is too high in relation to a portfolio of, say, $100,000—where it would amount to about 8.7% of your portfolio's value—you might consider a less expensive alternative. One such option could be trading options on the XSP ticker, the S&P 500 Mini, which are a tenth the size of the SPX options. This might offer a more cost-effective solution for portfolio hedging.
2. VIX Options:
VIX options, instruments tied to the Volatility Index (VIX), offer another robust hedging strategy, particularly useful during periods of increased market volatility. The VIX Index measures the market's expectation of future volatility, often spiking during market downturns when uncertainty is high. This characteristic makes it a suitable instrument for protection against market turmoil. By purchasing VIX call options, you can create a position that tends to increase in value during market downturns, effectively offsetting potential losses in your portfolio. As we delve into the real-world example, keep in mind that understanding and monitoring changes in implied volatility and the unique features of VIX options are critical to the success of this hedging approach.
In the above trade setup, you've purchased a VIX call option with a strike price of 12 expiring in December 2023. The premium paid for this option is $6.30, so your maximum risk is the premium paid, or $630. The high Delta of 0.93 indicates that for every 1 point move in the VIX, the price of the option will increase approximately $93.
Let's consider the scenario where VIX spikes to 30 before expiry. At the expiration date, the payoff from this call option would be the difference between the VIX level and the strike price, or $30 - $12 = $18. Since VIX options and futures are quoted in terms of VIX index points and each point equals $100, the payoff would be $18 * $100 = $1800.
After subtracting the initial premium paid of $630, the profit from this trade would be $1800 - $630 = $1170.
This gain on the VIX call option would help offset losses in your portfolio resulting from the market downturn. If the market doesn't decline, the maximum loss is limited to the premium paid for the option, or $630. This makes it a cost-effective and flexible tool for hedging against market declines.
In summary, hedging is an essential risk management technique that should be incorporated into every investor's strategy, especially when market conditions show signs of excessive bullish sentiment. Through the usage of various hedging tools such as options on indices and VIX options, investors can secure protective measures against potential market downturns, thus preserving portfolio value. These tools, while they come at a cost, can potentially yield significant benefits if the market experiences a decline, offsetting portfolio losses and providing peace of mind. Moreover, they can be tailored to suit an investor's individual risk tolerance and financial circumstances. In the ever-evolving landscape of the financial markets, where uncertainty is the only certainty, proactive risk mitigation strategies like hedging serve as a dependable safeguard. It's crucial to remember that timing, careful selection, and diligent management of these hedges are key to maximizing their effectiveness. Ultimately, successful hedging provides a much-needed balance to your investment portfolio, complementing diversification, and fortifying your financial resilience in the face of market adversity.
"The four most dangerous words in investing are: 'this time it's different.'" - Sir John Templeton
Options are complex, high-risk products and require knowledge, investment experience and, in many applications, high risk acceptance. We recommend that before you invest in options, you inform yourself well about the operation and risks. In Saxo Bank's Terms of Use you will find more information on this in the Important Information Options, Futures, Margin and Deficit Procedure. You can also consult the Essential Information Document of the option you want to invest in on Saxo Bank's website.
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