As noted in the last lesson, the $VIX is not a proper hedge for portfolios over the long-term. Using OTM long-term call or put options on the European-style, cash-settled $SPX index will provided more accuracy when hedging. Because the $SPX is an index option based on the S&P 500, the correlation between rising volatility and market declines will perform better as a portfolio hedge than the $VIX, which tracks $VIX futures.
If an investor's portfolio has an overall Delta of +116.00, some of the downside risk could be offset by purchasing OTM put options on the $SPX. Depending on how bullish the investor is, the negative Delta of the puts can be used to offset market pullbacks. Because the put options will have a lot of time until expiration, the Theta decay will be minimal. Also, because the investor is long the put options, a decline in the market and a rise in implied volatility will increase the premium of the put options, thereby offsetting the portfolio losses.
If an investor's portfolio has an overall Delta of -145.00, some of the upside risk could be offset by purchasing OTM call options on the $SPX. Depending on how bearish the investor is, the positive Delta of the calls can be used to offset market pullbacks. Because the call options will have a lot of time until expiration, the Theta decay will be minimal. Therefore, if the overall markets trade higher, the positive Delta in the call options will offset some of the losses experienced by the Delta negative positions in the portfolio.
Investors can also "lock in" their portfolio if they expect a large move is coming. This is known as a protective collar because the investor purchases lower strike put options while writing an equal number of higher strike call options with equal expirations. While upside potential will be capped, the investor also sets a floor on which they can experience losses. The sale of the call options offsets the cost of purchasing the put options.
Put Strike Price = Current Price - ( Current Price x Max Loss % )
Once the investor knows which strike price to select, they need to know how many contracts to purchase and write:
# of Contracts = Portfolio Value / ( Current Price x Multiplier )
Now the investor finds an OTM call option with the same expiration that is trading close to the same premium as the put option. By doing so, the cost of purchasing the put options will be offset by the premium received for writing the call options.
Example: An investor has a $10,000 portfolio
value that they want to hedge from a loss of no more than 5% over the
next 30 days. The investor decides to use the $XSP index, which has a
multiplier of 10 and is currently trading at $111 per share. First, the
investor needs to calculate what the closest strike price to a 5% move
down in the index would be:
$111 - ( 111 x .05% = 5.55 ) = $105.45
The investor would want to purchase the $105 put option. Next, the
investor needs to figure out how many put options to purchase:
$10,000 / ( 111 x 10 = 1,110 ) = 9.09 (round up to 10)
Therefore, the investor would want to purchase 10 $XSP 105
strike put options to set the floor. Assume in this situation that the
investor pays $1.25 per put contract. To offset, the investor writes
10 OTM call options with the same expiration date (can be different
strike price) that has a premium close to $1.25.
Once done, the investor will have created a position that locks in a 5% maximum loss and 5% maximum gain over the next 30 days.
Hedging techniques are very important to implement when future market direction is expected to be very volatile or profits need to be locked in.
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