When talking options most people first think of options as protection or hedges for other positions or even an entire portfolio. Options can be used in different ways to hedge/protect against black swan events like big market drops or crises. I will be presenting two possible hedge strategies and their effectiveness. The following best option hedging strategies are good to protect positions against black swan events (Market crashes) or just big moves down.
Protective Put Option Strategy
Probably one of the most common ways to hedge is hedging with put options. Most people use the protective puts strategy to hedge their stock positions. The goal with this strategy is to reduce the downside risk of single stock positions or the overall portfolio.
When using this strategy you should still be bullish on your stock position, but you are scared of a drop down and want to protect you from exactly that.
Buy OTM or ATM Put (for every 100 shares of stock)
Depending on the expected downward move you can either buy a put ATM or OTM. The bigger the move, the further you should buy OTM. But normally one would want to do this strategy multiple times, because no one knows when a bigger market move down will occur. Therefore, it is usually best to buy OTM options, because these are much cheaper.
Profit and Loss:
A protective put will turn a normally unlimited risk position into a limited risk position. From a certain price point (strike price) the put will offset all losses and thus defining the risk. The max loss will occur as soon as the price of the underlying moves further down than the strike price of the put. The upside on the other hand stays untouched and remains unlimited. But because you have to pay a sum to buy the put, the break even point of the overall strategy (including the stock) will be moved up a little. It can be calculated like this: Price paid for shares + Premium paid for put (+ commissions).
Maximum Loss: Premium Paid for Put + Price Paid for Shares + Commissions – Strike of Put
For protective puts Time Decay and Implied Volatility can be disregarded to some extinct, because you don’t buy them to make money, but to lose less money in case of a crash.
But this strategy would profit from a rise in Implied Volatility (IV). Therefore, it would theoretically be best to use it in a low IV environment.
Time Decay or the option Greek Theta works against a protective put. The long put constantly loses some of its extrinsic value over time. The amount of value lost every day increases the closer you get to expiration.
Theoretically you could also do all of this the other way around: If you are short stocks and want to protect yourself against a big upward move with a long call.
When to use this strategy:
This strategy is a very common hedging strategy and it can be used as protection for almost everything. It can be used for big market crashes, financial crises, drops in single specific positions. If you want to hedge your entire portfolio, protective puts in the S&P 500 are suitable, but only if the portfolio is more or less correlated to the S&P 500. To check the correlation, you should check out the betas. To learn what betas are read this. For single positions you’ll just have to buy the correct amount of puts for the underlying asset, which you want to hedge. This is great when you expect some specific news which only will affect a few securities and not the whole market.
But honestly I would rather recommend the following strategy if you want to hedge your entire portfolio.
VIX Calls Hedge Strategy
To understand this hedge strategy it is important to first understand what the VIX (aka. uncertainty index, fear gauge or the fear index) is. The VIX is a volatility index by the CBOE. It measures the implied volatility (IV) of the S&P 500. The S&P 500 is an index based on the top 500 companies listed on NASDAQ or the NYSE. This means that the S&P 500 can be thought of as an index for the whole market. This again means if implied volatility in the S&P 500 goes up the IV in the whole market is probably going up. Therefore, you could say that the VIX basically measures the IV of the whole market. It is commonly known that in case of price drops IV will rally. Thus, as soon as the S&P 500 price falls, its IV will go up and hence the VIX will rally. Concluding you can use this rally of the VIX to hedge your portfolio. This hedge strategy is all about profiting from a rise in the VIX.
This can be done by buying slightly OTM VIX call options. These will increase in value as soon as IV expands, which normally occurs in bearish markets and thus hedging losses from other bullish positions.
When to use this strategy:
This strategy is best used in times of very bearish markets or market crashes like in the financial crisis 2008. This won’t work as a hedge for small moves or for single positions, but only for an entire portfolio. But it is very important that your portfolio is somewhat correlated to the S&P 500, otherwise this strategy won’t work too well. The VIX calls act as a hedge to the S&P 500, many portfolios are quite similar to the S&P 500, but if not this strategy is not appropriate. To check correlation you can either check if your stocks are some of the ones also found in the S&P 500 or more precisely over a portfolios beta. A beta is a feature of some broker platforms and it shows the exact correlation to different assets like the S&P 500. To learn more about beta weighting check out this article. Otherwise, this strategy is logically best to use in time of rather low IV. If IV already is extremely high, this strategy won’t work.
Should you use these Strategies
I think these strategies both are good protection strategies for their own purposes. But I have to say that it is important to use these strategies with care. These strategies both can become rather expensive if they are used long term, because you constantly have to buy new options as soon as the old ones expire. Therefore, they can impact your portfolios performance quite negatively if no price drops occur. To underline this even more the CBOE actually have some benchmark indexes tracking performances of some hypothetical portfolios. They have both one index tracking the performance of the protective put strategy on the S&P 500 and one for the VIX call hedge strategy. Both of these strategies actually underperformed the S&P 500 by quite a lot long term. Even though these indexes go back and through the years of the crisis in 2008. The reason why these strategies underperformed the S&P 500 is because the bench marking was done very long term. Most of the time this protection was not really needed, because there were no big drops in the market and thus the protective options expired worthless. Only in the years of big bearish market events these strategies beat the S&P 500. (You can find the benchmark indexes here)
This doesn’t mean that the strategies are bad, but it just shows that it is not the best idea to constantly have this protection on. It is best to only have these hedges on in times of uncertainty and potential upcoming price drops. I know it is very hard to predict these upcoming events, because they are black swan events, which are unpredictable. But with a very good market awareness it is possible to at least have an impression on the state of thing and get a feeling if times are good or bad. In bad times it is a good idea to have some hedges for safety’s sake even if they sometimes weren’t necessary.
Otherwise, a good way to protect yourself from black swan events is through small position sizing, not too much allocation and diversification. To learn more about these other factors, check out this article.