Considering Portfolio Hedges with ETF & VIX Options

by CC December 9, 2014 2:18 pm • Commentary

There are no shortage of strategies and instruments to hedge a along portfolio of stocks, etfs and/or indices.  In today’s MorningWord (here) Dan had some thoughts on the initial steps that largely had to do with understanding what is in your portfolio and why.  But as volatility in most major global risk asset classes increases we want to look at specific hedging strategies using equity options.

As we head into year end, after a couple years of very healthy equity gains, volatility is picking up in FX markets, emerging market equities, commodities and global economic data. This is very likely to cause increased volatility in U.S. equities in the New Year.

The most common hedging technique is shorting index etfs vs a portfolio of stocks.  Hedge funds and other institutional investors use this approach to reduce exposure in the most liquid and simple way possible. The problem with this strategy is is is just that, simple. It’s essentially locking in market gains on that portion of the portfolio and gains to the upside are then dependent on outperformance of holdings vs the hedge. That’s why we prefer strategies with a defined risk profile where market  gains to the upside are still in play (up to a point) and downside protection is targeted to realistic correction levels.

The first way to hedge a portfolio of U.S. large cap  widely held stock is using options on the SPY. It’s important to size correctly by choosing breakevens on the structure that are informed by potential moves in your portfolio that you are worried about. (5%, 10%, 20%). Remember that if the SPY moves 10% that doesn’t mean your portfolio will only move 10% it could move much more.

When looking at the SPY as a hedging vehicle you realize just how ridiculous the rally off the October lows was. What that means is that if things do get volatile the range you have to protect against on the downside probably needs to be wider that normal. After a 26 point rally in a straight line pullbacks in the market could be pretty painful, pretty fast:

Screen Shot 2014-12-09 at 7.55.16 AM

The obvious levels of support are around 200, 194, 190 and 182. (marked in green) We can use these levels to inform our strikes:

Hypothetical SPY hedge (protecting down to Oct lows):

TRADE – Against 100 shares of SPY ($206) (representing your portfolio) buy the 195/180 vs 215 put spread collar for .50

– Buy 1 Feb 195 put for 2.25

– Sell 1 Feb 180 put at .80

– Sell 1 Feb 215 call at .95

Breakevens on the hedge on Feb expiration: Losses of up to 50c (vs your portfolio’s gains or losses) above 194.50 with total loss on hedge above 195. The hedge has gains vs your portfolio’s losses below 195 until 180 with 14.50 maximum gains on the hedge, offsetting about 7% in losses on a 11% move lower in the market. The risk to the upside is your gains in the SPY are capped at 214.50, up about 5% from here.

The way the stirkes are chosen is based on those 3 support levels indicated above. If the SPY pulls back to 200, protection isn;t really necessary, but below there things could get painful. If the market pulls back to the middle of the three green lines this protection saves a little money but also works as a sort of stop against further losses. At the bottom of the 3 green lines this protection is nearly maxed out and will have saved quite a bit in losses.


Or Long Vol Hedge

Another way to get protection on the portfolio is by being long volatility. We like to do something in the VIX options from time to time that has a pretty good risk reward profile. This is a very imperfect hedge against a portfolio but gives some long vol exposure near lows in the VIX that comes in handy when the market turns lower and others are scrambling for protection when implied volatility of puts explodes.

Hypothetical Long vol hedge:

TRADE – Against a long stock portfolio buy the VIX ($15.15) Jan 20/30 call spread vs selling the Jan 14 puts for .05

– Buy 1 Jan 20 call for 1.20

– Sell 1 Jan 30 call at .40

– Sell 1 Jan 14 put at .75

Breakevens on Jan expiration: It appears like you are “risking” only 5c on this trade, but that’s only true of the VIX closes above 14 on Jan expiration. Your actual risk is if the VIX closes below 14 in which case it’s more like you are risking somewhere between $1-2 (with a nightmare scenario where the VIX gets crushed possibly over $2) But for that risk, you have exposure to a spike to $30 in the VIX with the potential to participate in 9.95 of that.

Because the timing of expiration means it’s unlikely the call spread portion’s value is completely realized this is effectively risking about $1 to make $5 with outside chances of losing $2 or making closer to $10. We like this structure to buy vol without decay risk.