Dan teased this post a bit in his MorningWord when he discussed the elevated levels of implied vol and how that makes it difficult to use options to hedge a portfolio in already uncertain times. We’re going to detail a strategy that offers protection but takes advantage of elevated vols to establish both protection and a long entry lower in the broader market.
With the SPX down sharply from its recent highs and daily moves unlike anything we’ve seen in a few years implied volatility in single stock, etf and index options is likely to stay elevated for some time. But as Dan mentioned, that adds risk in trying to protect (or play) for downside moves because options are pricing in such large expected moves. But with elevated vol comes another opportunity for those willing to take on a slight amount of risk with their downside protection using skew to their advantage.
Skew is essentially the pricing of tail risk in options markets. While the expected move that Dan highlighted in the SPY straddle tells you what implied vol is expecting as far as moves before expiration, the skew tells you what options are pricing as far as unexpected moves outside of that. Here’s how the skew in the SPY looks right now, y0u’ll notice the massive curve higher as you go farther out of the money in put strikes in SPY:
What that means for trades is you definitely want to spread put purchases, and if possible do it in the form of a ratio, taking advantage of both elevated vol and elevated skew by selling more out of the money puts than you buy closer to the money.
There are a number of ways to do this and the biggest factor is how close to the money you want protection, where is and where is the level where you think the SPY is a no brainer own longer term (due to your risk of selling a put naked and being put the ETF lower)
Here’s the trade we like as a straight bearish trade, not as a portfolio hedge:
SPY ($192.50) Buy the Oct 180/170 1×2 put spread for .20 credit
- Buy 1 October 180 put for 3
- Sell 2 October 170 puts at 1.60 (3.20 total)
Break-even on October expiration:
Make 20c above 180, make up to 10.20 between 180 and 170. Profits begin to trail off below 170 as you are put the stock below 170 but at an effective price of 159.80 with profits at zero at that point.
Rationale – This of course is not a straight hedge as there’s risk of actually losing money if the market goes down too far. But for those willing to own the index much lower, the ratio spread provides protection while establishing an ideal entry level much lower than where the etf would be trading (up to 10.20 lower).
The three year chart below shows the range of profitability between 180 and 160:
For a a closer to the money hedge the strikes can be adjusted. For instance, the October 185/174 1×2 can be bought for even. That gives closer protection but of course also has a higher level where one is willing to go long the ETF.
The one thing to know about a ratio spread as a hedge is it might not feel like a hedge until we get closer to Oct expiration. In fact the 185/174 put 1×2 is flat deltas on entry. If the stock went to 174 tomorrow it wouldn’t even be up that much money and may actually be down money on a vol spike. But the point is the longer markets stayed lower below 185 the more that becomes a straight hedge as the 174’s lose deltas while the 185’s gain deltas. This is really a hedge for the next month more than the next week. For the next week you have to buy the spread on a 1 to 1 basis. But that costs money.