We’ve talked a lot recently about recent sky-high values of the Volatility Index, or “VIX”, and how elevated volatility increases the cost of options across the board. Expensive options contracts have put many investors in a quandary about how to profit in such unusual conditions; others who would like to hedge their portfolios against losses – and boy, have we seen a few losses lately – have also found that protection is very expensive. Today’s post offers some ideas for using options as hedges - without breaking the bank.

(If you’re just catching up: check out my posts on historically high VIX values. I’ve also explained a few options strategies that might make sense in the current super-volatile conditions, from upside-down split-strikes, back spreads, binary options on the SPX and VIX, and bear put spreads and butterflies.)

Why options – and hedging – is so pricey lately

As you may know, the VIX’s value is based on a weighted average of implied volatilities in the S&P 500 index (SPX) options. To illustrate how elevated VIX values have jacked up the total cost to hedge a portfolio, I went back in time and looked at a chain of options about a year old – 11/30/07, to be exact. Back then, the SPX index was trading around 1481, and the December 1480 strike put was trading for about $28 or $2,800 per contract. This option a year ago had 20 days remaining to expiration on 11/30/07 and the VIX index closed at 22.87. One year later, the difference is eye-opening: the S&P 500 index is around 896 (down almost 40%), and the December 895 strike put was trading for about $44 or $4,400  per contract. This option only has 18 days remaining to expiration, and the VIX index closed at 55.28. This is an outrageous increase, considering the index is quite a bit lower than last year. (The underlying index’s value plays a big role in its overall cost – check out my post on how options are priced to learn more about that.)

Given all this, it’s no surprise that many investors have decided not to hedge their portfolios using index options, simply because it’s too expensive. These prices are like buying homeowner’s insurance on your house in Florida when the hurricane season is already bearing down on you.

A cost-cutting tip: OTM hedging

Let’s walk through a few ideas for more affordable hedges. We’ll start with explaining how much coverage one S&P 500 index option provides. The quick-and-dirty formula that’s not 100% accurate but useful goes like this: take the value of the index and multiply by 100, because that’s the multiplier for the options in the index. So with the S&P 500 index around 896, we’d multiply that by 100 to get 89,600. That figure implies one put would cover about $89,600 of portfolio value. BIG DISCLAIMER, folks: this also implies your stock portfolio closely tracks the S&P 500 index. If you’re a small-cap investor, you might be better off repeating this math using the Russell 2000 (RUT); if you’re a Nasdaq fan, maybe the NDX index is more appropriate for you. Bottom line, your hedging index should track your underlying portfolio as closely as possible.

Let’s say we’re protecting $200,000 worth of stocks that closely track the S&P 500 index. We’d look to buy 2 or 3 puts depending on how much protection you would like (2 x $89,600 = $179,200). Looking out to January options with 46 days remaining until expiration and the SPX around 896, the 895 strike puts are trading for 65.50. If we bought two options the cost would be $13,100 or 6.5% or the portfolio. I know: ouch. Many investors flinch right there and forgo hedging protection because of its cost.

Now, keep in mind that this is the most expensive hedge because it’s very close to the current price of the index. It’s the equivalent of buying insurance with zero deductible, which as we all know ups your insurance premium costs quite a bit. If you want to lower the cost a bit, you can opt for a further OTM strike – that increases our “deductible” or risk, but much like insurance it lowers the cost of protection, too.
If we look 20 points down (about 2%) to the 875 strike January put, you’ll see the cost goes to 57.10 or $11,420 to buy 2 of the options. This move lowers your cost, but you’ll still face the risk from the current market price (896) to the strike (875) if you hold the options until expiration. So once again in the option marketplace there are trade-offs: lower hedging cost means accepting more risk.

Another cost-cutting tip: OTM spreads

Another way to lower your hedging costs is to sell another option much lower down in available strikes to help pay for the put you really want. Let’s stick with our previous example: buying 2 of the 875 strike January put for 57.10. We can then sell 2 of the 775 strike put, currently trading for 27.00. That makes the total cost of the trade 57.10 minus 27.00 or 30.10 net per spread. That’s $6,020 (30.10 x 200) for 2 spreads. Now the total hedging cost is 3% ($6020/$200,000) – not too shabby.

Keep in mind, though, that this hedge only protects us if the S&P 500 index stays between 875 and 775. In other words, it accomplishes our goal of lowering the cost of the hedge, but it’s also limits the amount of coverage. If the index loses more than 13.5% (896 – 775 = 121 points) by the January expiration our hedge will only help out a little - it does not provide coverage from 775 to zero.

Consider sector-specific hedges

My examples above applied to an entire stock portfolio, but you can apply these same tips to a single stock or sector of stocks (e.g. banks) by using options on individual securities or Exchange-Traded Funds (ETFs) representing whole sectors. That way you can get even more strategic, hedging your portfolio’s most vulnerable spots while keeping your hedging costs more reasonable. We’ll dig into more examples of this soon.

Regards,
Brian (Og)

[image: A Hedgehog’s Back by Denis Defreyne on flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at www.tradeking/ODD.

While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. 

Please be aware that early assignment of short options on American style expiration options may affect the overall max profit and loss potential of the strategy. Please plan accordingly for this possible occurrence.