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An Options Strategist’s Guide to Buying Portfolio Protection

Tony Zhang
March 2, 2022
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An Options Strategist’s Guide to Buying Portfolio Protection

As the disconnect continues to widen between fundamentals, economics and where equity market valuations, many investors have raised the question, when is it time to hedge the growing downside risks? To help investors answer this question, we explore the mechanics and best practices for seeking downside protection for a portfolio. To learn more about selecting optimal expiration dates and strike prices, please view our webinar on this topic.

 

What is a Portfolio Hedge?

A portfolio hedge acts as an insurance policy to protect your portfolio during a market correction. If the market declines, a portfolio hedge can reduce some of the losses in your stock portfolio. To perform a portfolio hedge, buy a put option on a broad-based index or ETF that closely correlates to your portfolio. The put option will profit when the market moves lower and this can offset some
of the losses from a portfolio – or what is known as an imperfect partial hedge. The challenge to this strategy is that put options can be very expensive, especially during a market correction. Moreover, constantly buying puts in anticipation of a pending market correction puts a large drag on a stock portfolio’s performance. Therefore, in this post we explore how professional portfolio
managers efficiently buy portfolio protection during a downturn.

 

The Perfect Hedge

The diagram below shows how buying a put option provides a portfolio hedge:

 

While the above chart is an example of an imperfect hedge, a perfect hedge actually exists and should be the first option to explore. A perfect hedge hides in plain sight; simply sell all holdings to cash and reinvest after the correction. This is by far the most cost-effective method for an investor to protect a portfolio against a market correction, only costing the commissions of selling and buying back the shares at a later time. However, for various reasons, this is not an option for every investor. A portfolio hedge should be considered when an investor holds a portfolio of stocks/ETFs, believes that the market will correct more than 5% and does not wish to sell any holdings.

 

Efficient Hedging Strategy

There are two main factors when considering a hedging strategy using put options – timing, and the hedging instrument.

TIMING
Timing of a portfolio hedge is arguably one of the most important factors and most difficult to execute for an efficient hedge. Many investors make the mistake of buying protection too early when markets are overbought and put protection is “very cheap”. To answer the question on timing, we turn to the statistics. The reality of market corrections is that they happen very
infrequently. Since September 2000 (239 months), the S&P TSX 60 Index has only seen monthly declines of more than 10% in 5 instances, 9 instances of declines greater than 7.5% and 23 times of declines greater than 5%. Portfolio hedges are only useful in declines greater than 5% generally, which occurs less than 10% of the time on a monthly rolling basis.

 

The most efficient timing for long term portfolio performance is buying a put after the market correction has started. This translates into more expensive puts, however, it prevents investors from buying protection when it is not needed. Our research shows that by buying puts too early, a portfolio will give up a significant portion of its upside to pay for the market correction that has not yet materialized. By buying a put during the correction, the initial cost may be higher, but it minimizes the cost of buying puts while waiting for the correction to take place. The timing to exit a hedge utilizes volatility metrics, which is inversely correlated to the market, to confirm market bottoms with a respective peak in volatility. By looking at the volatility index associated with the index that correlates to your portfolio, the investor can seek a confirmation of a market bottom.

 

HEDGING INSTRUMENT
It is important for an optimized hedge to pick an instrument that has a high correlation with your portfolio. For a portfolio that has a balanced composition of all Canadian sectors, buying puts on the XIU ETF can provide an efficient hedge. If a portfolio has a concentration in a specific sector or industry, picking an index that tracks that sector will provide better results. For example, portfolios that are concentrated in Financials could be better protected with the XFN ETF that tracks Canadian financial companies.

 

Hedging Size

The number of contracts that are required to hedge a portfolio depends on the size and the beta of the portfolio and is calculated using the following formula

Portfolio Beta (Portfolio Value ÷ Index Value ÷ 100) = # of contracts

 

 

Best Practices

EXPIRATION DATE
When choosing an expiration date for hedging purposes, a put option that expires in a 2-3 month time frame works best. This is because with everything held constant, longer dated options have lower theta (time-decay) per day. While further longer-dated options could further reduce time-decay, they are more expensive, have lower liquidity, and provide protection for time horizons
that is typically longer than the average market correction.

STRIKE PRICE
Strike prices for hedging purposes can be grouped into 2 categories. Catastrophic protection only provides protection only against a major downside correction with “out-of-the-money” put options. For investors seeking more comprehensive and complete coverage for their portfolios, should seek “in-the-money” put options which are more expensive.

 

Hedging Summary & Tips

Hedging a portfolio can decrease the volatility of a portfolio, increase the risk-adjusted returns and prevent a major drawdown during a market correction. There are many components to explore for efficient portfolio hedge, starting with the perfect hedge. If moving into cash is not a viable option for your portfolio, remember that buying puts on a portfolio is expensive, so timing is paramount. Buying protection after a correction has started will be more expensive but will greatly reduce the drag on a portfolio by minimizing time-decay. Furthermore, when markets are overbought and puts are “cheap”, selling covered calls can generate additional yield to reduce the cost of the puts.

 

Take advantage of free access to OptionsPlay Canada: www.optionsplay.com/tmx

 

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2021 Bourse de Montreal Inc. All rights reserved. Do not copy, distribute, sell or modify this document without Montreal Exchange’s prior written consent.  This information is provided for information purposes only. The views, opinions and advice provided in this article reflect those of the individual author. This article is not endorsed by TMX Group or its affiliated companies.  Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this article, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information.  This article is not intended to provide legal, accounting, tax, investment, financial or other advice and should not be relied upon for such advice.  The information provided is not an invitation to purchase securities listed on Toronto Stock Exchange, TSX Venture Exchange and/or Montreal Exchange.  TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication.  Toronto Stock Exchange, TSX, TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license.  Montreal Exchange and MX are the trademarks of Bourse de Montréal Inc.  All other trademarks used herein are the property of their respective owners.

Tony Zhang
Tony Zhang http://tmx.optionsplay.com

Head of Product Strategy for OptionsPlay

OptionsPlay

Tony Zhang is a specialist in the financial services industry with over a decade of experience spanning product development, research and market strategist roles across equities, foreign exchange and derivatives. As the current Head of Product Strategy for OptionsPlay, Tony leads the research and development of their OptionsPlay Ideas & Portfolio platform. He has leveraged his interest in financial technology and product development to provide innovative, reimagined solutions to clients and the users they seek to serve. Previously he spent 7 years at FOREX.com with a capital markets and research background as a market strategist specializing in equity and FX derivatives markets.

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