A Simple (Advanced) Lesson in Option Hedging

  • SumoMe

I know you’re busy.  So in everyone’s best interest I will state right at the outset that if you do not now – and if you are pretty sure you never will in the future – hedge your stock portfolio with stock index or stock ETF options, you can probably go ahead and stop reading right here.

But I do appreciate you stopping by, and in the immortal words of Jed Clampett, “Ya all come back now, ya hear?”

All right, now that that is out of the way, let’s talk about hedging with options without trying to “make it understandable” to people who not know nor care about options.

A Word of Warning to First Time Hedgers

Most people’s first foray into hedging involves something of a “Hey, I’ll think I’ll give this a shot” mentality.  Nothing wrong with that really.  The problem is that too many investors and traders are unprepared mentally for the “Lose/Lose” nature of hedging.  What I mean by that is this:

If you spend money to hedge against say a decline in the stock market, typically one of two things will happen:

1) The stock market goes up instead of down and the money you spent to hedge will be lost.

2) The stock market goes down.  Your hedge may cover all of your losses, but my experience has been that in most cases it will only offset a portion of your portfolio loss.  So while you may feel good about the fact that you’ve reduced your loss of equity, in the end you still lost equity.

So you have to be prepared for these possibilities.

Two Questions to ask before Hedging

1) What is it that I am attempting to hedge against?

2) How do I get the most “bang” for my hedging “buck?”

The best way to illustrate this is with an example.  For the record the example I am about to show is not a “recommendation”, only an example.  Although also for the record, if the stock market does turn down tomorrow and revisit the low of its recent trading range I will probably try claim that I “called the top with uncanny accuracy.”  Sorry, it’s just my nature.

Hedging with SPY

In Figure 1 we see a bar chart for ticker SPY.  1 Figure 1 – SPY trying to break out to the upside (Courtesty: AIQ TradingExpert)

One could argue that it is struggling to break out to the upside and that if it fails to do so then a trip back down to the low of the recent trading range is a good possibility.  You may buy that scenario or not, but the point is simply to ask the question, “is there a way to hedge against such a decline?”

Would I ask the question if I though the answer was “No?”

The low of the recent range for SPY was 197.86, so we will look for a way to hedge a move back down to that price level.  That is our answer to Question #1 above.  Now let’s look at some potential answers to Question#2.

Figures 2 illustrates one possible idea which involves simply buying the April 197 SPY put for $173.  We will look at the risk graph for this trade in a moment after we find something to compare it to. 2Figure 2 – Buying 1 SPY April 197 put (Courtesy: www.OptionsAnalysis.com)

A “simple advanced” alternative to this position would be to buy an “Out-of-the-money butterfly” as illustrated in Figure 3. This involves:

*Buying 2 April 197 puts

*Selling 4 April 180 puts

Buying 2 April 163 puts 3Figure 3 – Buy 2 SPY April 197-180-163 put butterflies (Courtesy: www.OptionsAnalysis.com)

So why bother with all of this?  Well, it goes back to the two questions I told you to ask earlier.  In this case we are looking for a way to hedge a move by SPY back down to about 197.80.  We also want to get the most bang for our buck.  Let’s look at why the trade in Figure 3 is a better choice than the trade in Figure 2.

Comparisons

In Figure 4 we see the risk graph for buying 1 April 197 put and in Figure 5 we see the risk graph for buying 2 April 197-180-163 butterfly spreads.4 Figure 4 – Risk Graph for 1 April 197 put (Courtesy: www.OptionsAnalysis.com)5Figure 5 – Risk Graph for 2 April 197-180-163 butterfly spreads (Courtesy: www.OptionsAnalysis.com)

Two key things to note:

1) The cost of both trades is about the same ($180 for the butterfly and $173 for the straight put option)

2) The butterfly spread offers more “bang for the buck.”

A close look at Figure 4 reveals that the put option will see its profit potential greatly diminished as time goes by due to time decay.  If SPY hit 197.80 immediately the profit would be about $380.  If it did not hit 197.80 until March 29th, the profit would be only about $120.

Now take another close look at Figure 5.  Through at least 3/29 regardless of when (and of course if) SPY falls to 197.80 the butterfly spread offers a consistent profit range of $330 to $370.

For all of you “Greeks Geeks” out there (“Hi, my name is Jay”), the key difference between these positions is seen by looking at the “Theta” values in Figures 2 and 3.  Theta is the option greek that tells you how much a particular position will gain or loss based solely on time decay.  The straight 197 put trade has a theta of -$3.87.  This simply tells us that if price and volatility remain unchanged today, this trade will still lose $3.87 solely due to time decay.  Hence the reason the risk curve lines keep moving in the wrong direction as time passes.  The butterfly spread in Figure 3 has a theta of only -$1.66.  Hence the reason the risk curves for this trade do not “face into the sunset” until much closer to expiration.

Figure 6 summarizes the expected profit for both trades if SPY falls to 197.80 by a given date.

Date SPY hits 197.80 197 Put Profit 197-180-163 Profit
2/19 +$380 +$340
3/10 +$270 +$370
3/29 +$120 +$330

Figure 6 – Expected Profit from both trades based on time

The bottom line is that the butterfly spread maintains roughly the same profit potential into late March, whereas the straight put position will see some of its profit potential vanish with each passing day due to time decay.

Summary

So is this a “great trade”?  Well, I think that one is clearly in the eye of the beholder.  In any event, just like a hedge can only serve a limited purpose, so to with this article.  I for one cannot predict if SPY will break out to the upside or reverse back down.  But I am not really trying to make any predictions here.  The sole purpose of this article is to illustrate:

1) The fact that there are ways to use options to hedge positions

2) Using the right strategy can generate more profit potential and/or a higher probability of profit for the same – and at times, less – cost.

Jay Kaeppel

One thought on “A Simple (Advanced) Lesson in Option Hedging

  1. Jay,
    Along the same lines as hedging, sort of, and if you’re looking for article ideas, now might be a good time to revisit an article you did after the market melt down in 2008-2009 (spring or summer 2009 timeframe if I remember), where you discussed the beauty of bailing out of all positions if the 50 DMA drops below the 200 DMA, and re-entering when the 50 crosses back above. At the time of your article I had just lost a large portion of my portfolio as I watched it melt during the financial crisis, and I was rather ticked off at you for not telling me this neat little trick when the market was at its highs, not at its lows. I have since forgiven you, and now I’ve incorporated this knowledge into my financial plan. I not only sleep better at night, but I’m actually looking forward to the next major sell off so I can bail when the markets are relatively high and re-enter when they are relatively low, and make some great gains on the way back up…… Keith

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