As we traveled across Canada over the last month on behalf of the M-X, I met many retail investors concerned about the markets and the fate of their portfolios. While some were concerned about the risk associated with individual holdings, many were skeptical as to how much longer the stock market in general could hold up. While the Canadian equity market has underperformed comparative to its U.S. counterparts, history has demonstrated that when the U.S. markets roll over, so does the Canadian market. As the old saying goes “when the tide goes out, all ships sink”
We spend a lot of time focusing on the protective put strategy which is a very effective way of hedging risk in an individual stock. As the share value declines, put options will increase in value and subsequently offset a portion of the loss incurred in that individual stock. However, purchasing puts on each individual security within the portfolio can be very costly.
Since a diversified portfolio will usually follow the market, a more cost effective way to hedge risk would be to use SXO options. SXO options are priced based on the value of the S&P/TSX 60. As the index drops in value, an SXO put option will increase in value.
Important Contract Specifications
Trading Units
$10.00 X one S&P/TSX 60 point. Price quoted in index points expressed to two decimals.
Avantages
Effectively hedging a portfolio takes a little effort on the part of the investor. Since most portfolios will not exactly track the index due to unique stock selection and weighting, the portfolio beta must be calculated. The beta of a portfolio indicates the volatility of its return in comparison to an index. In this case, the S&P/TSX 60 index will be used as a benchmark.
A beta of 1 represents the market. Therefore a portfolio that moves more than the market over time will have a beta greater than 1 and a portfolio that moves less than the market will have a value below 1.
Each of the stocks that you hold in your portfolio will have its own beta. I found the information I needed at www.financialpost.com.
If there are share positions of different weightings, the beta of the stock must be multiplied by the weighting in the portfolio. Once this is determined for each of the holdings the average beta may be calculated.
Sample $100,000.00 Portfolio, equal weighted
On May 14th, 2013:
Equation: portfolio value X beta
index value X 10
Example: $100,000 X 1.16 = approximately 16 SXO put contracts
719 X 10
$22.80 X 10 = $228.00/contract
$228.00 X 16 contracts = $3648.00
Without the hedge, a 10% drop in the index would result in an 11.6% drop in the portfolio or $11,600.00
If the index dropped 10% from 719 down to 647, the put would have the following value on expiration:
715 strike – 647 index settlement value = 68
68 – $22.85 cost = 45.15
45.15 X 10 X 16 = $7224.00 cash settled in Canadian dollars
The portfolio is worth $88,400.00 considering the 11.6% drop; however the put option profit is $7224.00. The result is that the portfolio is worth $95,624.00
By using the SXO options to hedge the overall risk exposure of the portfolio, the investor has limited a potential 11.6% drop in value to approximately 4% without having to sell any shares.
It should be noted that an investor wishing to offset the cost of the SXO put could sell a call option to create collar strategy provided that the portfolio is not held in a registered account.
For more insight into SXO trading specifications and strategies check out the following webinar links:
Introduction to S&P/TSX60 Options-SXO
Gaining Market Exposure with SXO Options
Hedging with SXO Options
CEO and Director of Business Development
R.N. Croft Financial Group
Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for Learn-To-Trade.com and an instructor for the TMX Montreal Exchange.