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Hedging a Portfolio with Options

Tony Zhang
July 17, 2019
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Hedging a Portfolio with Options

Hedging a portfolio against a correction in the markets is conceptually easy to understand. However, in practice there are multiple variables to consider and each requires customization based on portfolio sizing and market outlooks. To understand how to execute an efficient hedge on your portfolio, we’ve put together this practical guide. Variables to consider include market outlook, hedging instrument, contract sizing, expiration date and strike price.

Before evaluating a portfolio hedge, it’s important to understand that the most effective hedge for a portfolio is to move its assets to cash when anticipating a market correction, and reinvest when the market recovers. However, moving to cash is not always an option for every investor. That is when using Put options to hedge a portfolio should be considered.

To learn more about hedging strategies, please view our recent webinar.

Strategy

Protecting a portfolio against a market correction is achieved by buying Put options on an index or ETF that is closely correlated to that portfolio. Put options provide unlimited downside protection with a fixed cost. Simply put, it can be viewed as buying an insurance policy with a one-time premium. Put options should only be purchased during a market correction and generally should not be used ahead of time to anticipate an upcoming correction. Due to the expensive nature of hedging, it is also critical to exit a hedge quickly, once a market correction is complete. Timing of entry and exit of a hedge should utilize “fear gauges” such as the S&P/TSX 60 VIX Index (VIXC).

Hedging Instrument

Picking the right instrument to hedge your portfolio can be challenging. Most diversified portfolios should use a broad-based index as the hedging instrument. Protecting a portfolio during a market correction can be achieved efficiently using Index or ETF Options. Indices and ETFs on the S&P/TSX 60 Index provide a wide selection of expiration, strikes and contract sizes that are well suited for hedging a portfolio against market corrections greater than 3-5%.

Cash settled, European-style Index options provide additional cost efficiencies for hedging vs. traditional ETF options. SXO index options leverage the full index value of the S&P/TSX 60 while XIU ETF provides roughly 1/40th the exposure to the same flagship index. These two products provide different notional sizing to fit the needs of retail and institutional customers.

Contract Sizing

Determining the number of Put contracts to purchase for a hedge can be calculated using the following formula:

$ Portfolio Value ÷ Index Value ÷ 100 (SXO multiplier[1]) = Put Contracts to Purchase

Example: $500,000 ÷ 986 (SXO Index Value) ÷ 100 = 5 Contracts of SXO

Expiration Dates

Options on broad based indices generally provide a wide range of expiration dates, giving investors flexibility in choosing the appropriate time frames. Most portfolio hedges typically last a couple of weeks to a couple of months. It’s best to choose an expiration date that is at least 1-2 months beyond the expected correction period. Longer-dated options have less time decay (Theta) which helps reduce the cost of holding the hedge. Example: If an investor anticipates a 5% drop in the next month, it’s best to buy a 2-3 month option.

Strike Prices

Investors have flexibility when choosing strike prices which provide various degrees of protection. Similar to insurance policies, investors can choose between catastrophic or comprehensive coverage.

Strategy 1: Buy “Out-of-the-Money” OTM Puts (30-40 Delta)

Catastrophic Coverage – Provides downside protection only in a major market correction

Cost: Typically 1-2% of the underlying portfolio

Strategy 2: Buy “In-the-Money” ITM Puts (50-60 Delta)

Comprehensive Coverage – Provides downside protection with any market correction
Cost: Typically 3-5% of the underlying portfolio

Example:

Hedging a $1,000,000 Portfolio using SXO (S&P/TSX 60 Index Options) on July 8th, 2019

Catastrophic Coverage: Buy 10 Contracts, 2-Month 30-Delta Put @ $17,500 (1.75% of Portfolio)
Comprehensive Coverage: Buy 10 Contracts, 2-Month 60-Delta Put @ $37,500 (3.75% of Portfolio)

Table 1 – Catastrophic Protection with OTM Puts upon Expiration

Source: OptionsPlay
Table 2 – Comprehensive Protection with ITM Puts upon Expiration

Source: OptionsPlay

Despite ITM Puts costing more than twice the amount of the OTM puts, they provide far better protection during a correction while maintaining a smaller portfolio loss even when the market does not move lower. Only if the market rallies significantly higher, does the comprehensive insurance underperform the portfolio with only catastrophic insurance.

Summary

Hedging a portfolio efficiently against a market correction can be achieved using Put options on broad based index products and ETFs. The flexibility of S&P TSX 60 ETF and index options provides both retail and institutional investors the ability to stay invested while reducing exposure during market downturns. Understanding the impact of different hedges is critical to a successful hedging strategy. Utilize the OptionsPlay Platform to visualize and calculate portfolio-hedging strategies for risk and reward metrics on your underlying portfolio. To learn more about hedging strategies, please view our recent webinar.

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

[1] https://www.m-x.ca/produits_indices_sxo_en.php

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.

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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