In this week’s Options corner I will take a look at how we might use Options to hedge our portfolios.
Of course, the simplest way to do this would be to just buy a Put Option – but is this the best/most effective way to protect ourselves? Let’s take a look at this and the cost/benefits of a number of alternatives:
- The Purchase of a single At-The-Money (ATM) Put Option:
Using SPY as our instrument to provide the hedge and with SPY trading at ~$334 our ATM Put Option would look like this:
I have chosen to use December Put Options since this hedge would take us through the November election period that probably offers the most uncertainty for the markets. In addition, I might choose to exit before expiry so as to reduce the impact of time decay that will hurt long positions (that have negative Theta). For comparative purposes I will assume that I may choose to exit this position on 24 November if I have not done so before that time.
Note that the above position has negative Delta (bearish) and negative Theta (i.e. is susceptible to time premium decay)
2. As an alternative to this I might also consider the purchase of a cheaper Out-of-The-Money (OTM) Option, such as the Dec 305 strike Put:
So that we can compare risk/reward the above figure shows the PnL Risk Graph for the purchase of 2 contracts. Total investment/maximum risk is ~$2,000 – similar to the ATM Puts in Alt #1.
This position also has negative Delta and negative Theta.
I also need to establish a probable price “target” for the trade – so I look at the price chart:
Looking at the chart, the obvious target might be the March low of ~$220. However, we might expect support near recent (June) lows of ~$300 and May consolidation levels of ~$285. For the purpose of this analysis I will set my “target level at $285 – that is also in the range of the technical Fibonacci retracement levels at 50% and 61.8% retracement from the recent highs to the March lows.
3. Having set this target, as a possible maximum move, I might consider the purchase of a vertical spread:
This position has a maximum profit limit of ~$6,000 with the same ~$2,000 risk. Delta is again negative (bearish) and Theta starts off negative but, if price drops below ~$310, we go through an inflection point and Theta switches to positive – where time decay works in our favor. This is the trade-off between limiting profit and limiting risk – that is why we need to have a realistic belief in where prices might go.
4. If we don’t believe that price will go significantly below $285 we might also consider a “Butterfly” trade – that looks like this:
Where we can buy 3 contracts while keeping risk below $2,000.
This trade also has negative Delta and negative Theta to begin with but theta again goes through an inflection point at about $325. This trade looks good unless price falls below ~$250 and, if held to maturity – that we wouldn’t do – could show a loss below $250.
5. If we wanted to avoid the possibility of downside losses we could modify the “standard” Butterfly and create a “Broken Wing Butterfly” (BWB) that might look something like this:
Again, we can buy 3 Contracts of this position and still maintain our risk level to less than $2,000. The position has the same “Greek” characteristics of the standard Butterfly position, but we have no downside risk.
Let’s summarize the performance of these positions:
The right-hand column shows the maximum profit of each position assuming the position is held to maturity and closes at the necessary price – for the “butterfly’s” this is $285 and is obviously an unrealistic high probability outcome.
The maximum risk on each position is the price we pay to place the trade (Cost column).
To restrict time decay (in positions where we have negative Theta) a reasonable strategy would be to exit the trade ~1 month before expiry (say 24 November). The chart therefore shows anticipated profits/losses at different price levels ($220, $285 and $370). Since the time taken to reach a given price affects PnL, the table also shows the Profits at the $285 “target” price on different dates (25 days apart).
The table also shows the losses should price remain unchanged on the planned exit date (24 Nov) as well as losses should price move up to $370 by that date (and the position hasn’t already been exited. Also shown is the break-even price, or the price above which we might see a loss (on 24 Nov) – this is not too far from the current price for all 5 potential positions.
This should be enough information to allow a trader to choose a portfolio hedge (sized to match portfolio risk). Which option would you choose? (ignore my technical analysis if you have other “target” opinions).
Obviously these 5 examples are designed to meet my “targets” as described above and, if you see different targets, these might need different strike configurations but the objective of this post is just to show the process that might be used to look for/compare possible hedge positions. The positions themselves are not overly complicated, each comprising only 1-3 Option legs, but it’s where we place the strikes that controls risk/reward.