Hedging a Diversified Portfolio

It is an accepted reality among investors that we are living in a global economy. If you take a look at when most of the volatility in the equity markets has occurred, it is generally around a Bank of Canada (BOC), Federal Reserve Open Market Committee (FOMC) or an European Central Bank (ECB) rate announcement and subsequent press conference. These kinds of risk are known as systematic risk and are based on broader geo-political and economic considerations. The challenge is that it is difficult to hedge against this kind of broad based risk. Many investors hold a diversified portfolio of companies representing different sectors. While this reduces the concentration of risk to any one specific market sector, there are times when there is no where to hide. When an investor senses risk in any one stock, protective puts can be purchased to offset the potential loss. Patrick offered some insight into this in his the post titled Have the Rail Stocks Been Derailed? This is known as unsystematic risk . This kind of risk can be managed with some cost effectiveness as puts need only be purchased on the individual stock. The dilemma for the investor arises when there is concern for the entire portfolio in which case purchasing puts on all of the securities held may not be cost effective or even possible depending on options eligibility. I’ll be presenting at the Options Education Day in Vancouver on May 30th along with Patrick Ceresna, Richard Croft and Marty Kearny. Click here for topics and registration details. While there are a number of great topics lined up, my focus will be on “4 Ways To Hedge Against Risk”. One of the approaches that I cover is the use of index options to hedge a diversified portfolio, more specifically SXO options. SXO options are priced based on the S&P/TSX 60. For a complete overview of the contract specifications check out this Fact Sheet. If the expectation is that a broad based market decline is going to impact the value of a diversified portfolio, rather then buying puts on each stock, the risk my be hedged by purchasing puts on the SXO. As the broader market declines, the expectation is that the portfolio will drop in relation, the extent of which will be dependent upon the shares held in the portfolio and their weightings. In general, to calculate the number of SXO puts to purchase, the investor would use the following equation: Portfolio Value / (S&P/TSX 60 Value X $10.00), where $10.00 represents the standardized point value of the contract. This would offer the investor what is known as an imperfect hedge where a drop in the S&P/TSX 60 index may not be the exact same as a drop in the portfolio. To calculate the number of contracts that would more closely hedge the portfolio based on a drop in the index, the portfolio beta may be calculated. The beta represents the amount of variance in the value of a portfolio comparative to the overall market. In this case, the S&P/TSX 60 is representing the “overall market”. With the beta of the index considered to be 1.00, a stock may have a beta higher or lower then 1 depending upon how correlated or uncorrelated it’s share price is with that of the market. You can calculate your portfolio beta by finding the beta of each stock, adding them up and then dividing that number by the number of shares in your portfolio. If the shares have different weightings in your portfolio, you first multiply the beta by the weighting percent and then, execute the same calculation. To find the beta of a company, I use TMX Money and the “Get Quote” feature at the top of the homepage. Once this Beta number is established, the following equation would be applied: (Portfolio Value X Beta) / (S&P/TSX 60 Value X $10.00) One additional benefit of SXO options is that they are cash settled. This means that the contract is settled for the difference between the strike price and the closing price of the index. Rather than shares exchanging hands, if the option has any intrinsic value, it is deposited in to the investors account. Comparatively, ETF and equity options are settled through the purchase and sale of the underlying shares. For the investor who wishes to hedge the risk in their portfolio, but does not want to actually close any positions, this becomes an attractive solution. As the portfolio value drops, the SXO option will offset a portion of the cash difference. Hedging is an important consideration in any investment plan. Investors taking the initiative to manage their own capital need to be aware of the choices that they have to manage risk. While the markets have continued to advance higher year over year, history has taught us that corrections are an inevitable part in the the stock market cycle. By learning about SXO options and how to hedge a diversified portfolio, investors can be prepared to preserve their profits and protect their capital when market conditions change. For more information on portfolio hedging, please join us on May 30th for the Vancouver Options Education Day. For those of you that can’t make it, there are a number of videos available at www.m-x.tv to help you understand how to use SXO index options to meet a variety of objectives.