How to Use Options to Hedge Your Portfolio
If you read the newspaper or watched the nightly news during the past several weeks, you might assume the world as we know it is ready to implode. For the past several weeks, the media and the markets have been worrying about a return of the Cold War era, the escalating violence in Gaza, Portuguese banks collapsing and an Argentinean default.
And now, there’s even more to be concerned about; the United States is once again involved with military action in Iraq and there is the potential for an Ebola outbreak.
Could it possibly get any worse?
Sure it could.
Or it’s possible that we will look back in a couple of months to see that these “flare ups” were just minor bumps in the road.
That said, the markets have certainly become concerned about these situations and have fallen approximately 3% in the last several weeks. While 3% feels like a lot, we need to remember that the S&P 500 is still up approximately 4% for the year and is coming off a year in which it was up 30%.
So if you are concerned about what these headlines could do to your portfolio, how can you hedge yourself against a major down-move in the markets?
One way is to use options to hedge your portfolio.
Here are some hedging strategies.
Because I can’t possibly know what you have in your portfolio, I’ll base some hedging strategies on the SPDR S&P 500 ETF (SPY), which corresponds to the price and yield performance of the S&P 500 Index.
(Note: You may not be allowed to hedge your mutual fund holdings by trading the SPY. For instance, if you own mutual fund XYZ, your broker may not allow you to sell calls in the SPY because they don’t move in exact correlation. But that is a conversation you should have with your brokerage provider.)
As of Friday’s close, the SPY was trading at 193. For this exercise, I’m going to assume that you own 1,000 shares of SPY, which is currently worth $193,000.
Here are a couple of different strategies you can use to “hedge” your portfolio.
A covered call is a risk-reducing strategy; in this, a call option is written (sold) against an existing stock position on a share-for-share basis. The call is said to be “covered” by the underlying stock, which could be delivered if the call option is exercised.
This is a great way to create yield in your portfolio, though I will say it does not “hedge” you entirely. If the SPY were to drop dramatically, you would collect the premium taken in by selling the calls as they will have expired worthless, but you would still be long the stock.
So based on our hypothetical example, you own 1,000 shares of the SPY, and so you are able to sell 10 calls against your stock so that you are covered. (If you owned 100 shares you could sell one call.)
For this exercise, I will look five months out, and 4% out of the money. Based on this criteria, you could sell 10 January 200 Calls for $3.50.
If the SPY stays below 200 by January expiration, you would collect $3,500. If you do that twice a year, you would collect $7,000, which in this virtual zero interest rate environment, is a nice yield. On the other hand, if the SPY were to close above 200 on January expiration, you would have your stock called away from you.
You can choose any number of months or strikes. For instance, you can sell five November 200 Calls and five January 200 Calls. There are seemingly limitless amounts of calls you can sell, in many different combinations.
This is a profit and loss graph of the hypothetical January 200 Covered Call position:
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Once again, assuming you own 1,000 shares of the SPY, the truest hedge would be to buy 10 puts against your stock position. If the SPY were to drop below your put’s strike price, you could simply exercise your puts, and you would be out of your entire stock position. The upside to this strategy is that you do not cap the potential profit if the SPY price continues to rise.
For instance, you could buy 10 October 190 Puts for $4.00. So if the SPY were to drop below 190, you would exercise your puts, which allows you to sell your stock, and you would be taken out of your SPY stock position. However, you have to pay $4.00 per put, or $4,000 for your 1,000 shares, for this insurance. But with the price of “insurance” in the options world at historically low levels, this is an extremely cheap protection trade.
Again, you can choose any number of strikes and timeframes for this strategy.
This is a profit and loss graph of the hypothetical put purchase position:
You can use any of these strategies against any of your equity or index holdings. If you own a lot of Boeing (BA) or General Electric (GE) stock for instance, you can hedge your stock positions with these strategies.
If you want to hedge your mutual fund holdings, talk to your brokerage provider to see if you can implement strategies like these.
Your guide to successful options trading,
Chief Analyst, Cabot Options Trader/Cabot Options Trader Pro
P.S. If you would like more of my commentary on the market and what’s trading in the marketplace please follow me on twitter @Jacob_Mintz.