10 Common Options Questions Series: # 6 How can I use index options to hedge my portfolio? (1018-84KJ)
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Agenda 01 Portfolio Hedging Strategy 02 Portfolio Hedging Characteristics 03 Index Hedging 04 Index Hedging Example
01 Portfolio Hedging Strategy 5
01 Portfolio Hedging Strategy Hedging Defined In financial terms, hedging is a strategy designed to reduce the risk of adverse price movements for a given asset Examples: liquidate (reduce exposure); utilize inversely correlated financial products; utilize protective option strategies (protective puts/collars)* There are various hedging techniques that can be employed Cost is driven by both the level of protection desired and the length of time that the protection is in place Today s discussion will focus on protecting a portfolio against a significant market correction (i.e. systemic risk) *Certain offsetting transactions may carry tax implications, be sure to contact your tax advisor if you aren t clear on the impact of establishing such positions. 6
01 Portfolio Hedging Strategy Why consider a portfolio hedging strategy? Protect unrealized profits on existing positions without selling holdings Reduce downside risk of adverse price movements on existing positions Mitigate market risk without eliminating potential upside gains 7
02 Portfolio Hedging Considerations 8
02 Portfolio Hedging Characteristics Portfolio Hedging Considerations Finding a product that is highly correlated to an individual portfolio can be difficult: A well-diversified portfolio consists of multiple asset classes with multiple positions so that the weight of any security is small Individual portfolios vary Hedging each position can be difficult to manage: Establishing a hedge on each individual position requires monitoring and extensive position management around expiration. This also can be costly and time consuming. Selling may be a viable option but this potentially presents issues: Are you ok with the tax liability? When/where do you reinvest the cash? What practical portfolio hedging techniques are available? 9
02 Portfolio Hedging Characteristics The Most Important Hedging Characteristics Effectiveness: what level of protection will I get? Effective hedge can largely offset the losses of the primary assets Cost: how much will it cost to establish the hedge? Typically has a cost, but evaluating both the potential benefit as well as the associated cost is critical in investing! Time: how long do I need the protection in place? Could be for upcoming news announcement or geopolitical event with potential market ramifications. Important questions to ask are, How might the hedge help me, how much am I willing to pay for it, and for how long? 10
03 Portfolio Hedging with Index Puts 11
Index Puts How do they hedge portfolios? 01 Index options track larger indexes such as the S&P 500, Nasdaq, & Russell 02 Index puts increase in value when overall markets decline and also when volatility increases 03 Since stocks tend to correlate, investors can buy Index put options to hedge a diversified stock portfolio Index options track larger stock indexes such as S&P, Nasdaq, or Russell 12
03 Portfolio Hedging with Index Puts The Case for Using Broad-Based Index Put Options as a Hedge 1. Favorable Tax Treatment: Many broad-based index options are considered 1256 contracts and are taxed at a 60% long-term/40% shortterm rate. Note: 1256 contracts must be marked to market at year end 2. Cash Settlement: Index options are cash settled (potentially easier to manage around expiration) and indices that are European-Style Options eliminate early assignment risk. 3. Leverage: Leveraged products, such as options, hold the potential to increase much more (on a % basis) vs. the underlying. This characteristic is desirable when attempting to establish a cost efficient, effective hedge. Note: leverage is a double-edged sword which can work significantly against you just as easily as it can work in your favor. 13
03 Portfolio Hedging with Index Puts Brief Summary of Beta Beta: a measure of the volatility of a security or portfolio relative to the market as a whole If portfolio has Beta less than 1.0, this indicates portfolio has moved up or down less than the overall market ex. SPX -5%, Portfolio -4%, then portfolio Beta = 0.8 If a portfolio has Beta equal to 1.0, this indicates portfolio has moved up or down the same % as the overall market ex. SPX -5%, Portfolio -5%, then portfolio Beta = 1.0 If a portfolio has Beta more than 1.0, this indicates the portfolio has moved up or down more than the overall market ex. SPX -5%, Portfolio -8%, then portfolio Beta = 1.6 14
03 Portfolio Hedging with Index Puts Some Important Considerations When Selecting a Broad-Based Index as a Hedging Instrument 1. There are several broad-based indices that have options: $SPX, $DJI, $NDX, $RUT etc. 2. It s important to understand the correlation between your portfolio and a specific index. For example, calculate how much your portfolio was up/down over a year and compare that % to how much a given index was up/down during that same time frame. You can also perform calculations on multiple years to get a better gauge of the correlation. 3. If you decide to use broad-based index options to hedge your portfolio, consider selecting an index which is closely correlated to your individual portfolio (i.e. has a Beta of ~1.0). The higher the Beta of your portfolio vs. an index the less effective that index may be as a hedging instrument. 15
03 Portfolio Hedging with Index Puts Steps to Index Put Hedging Determine Notional Value of portfolio what is the current dollar value of the portfolio Choose the Index that best correlates to your portfolio for the purpose of hedging Calculate number of shares the portfolio equates to in Index terms and determine number of puts to purchase Decide how long you want the hedge, at what level, or strike, and how much you are willing to pay 16
04 Index Hedging Example 17
04 Index Hedging Example Portfolio Hedging Example Assume: 1. You own a $850,000 portfolio of diversified equities 2. The portfolio is highly correlated to the SPX The Beta of the overall portfolio (relative to the SPX) is 1.00 3. You are concerned that the SPX may sell off substantially over the next 2-3 months (and don t want to liquidate your equity positions) 4. You are willing to sustain a 10% market sell-off but no more than that 5. You would like to evaluate the cost and effectiveness of using SPX put options to provide downside portfolio protection The example is hypothetical and provided for illustrative purposes only. Please Note: In this example we are using SPX put options as our hedging instrument but please remember that there are other broad-based index options to select from which may have a higher correlation to your individual portfolio 18
04 Index Hedging Example Portfolio Hedging Example (-10% details) Date: August 15th, 2018 SPX = 2,800 VIX = 16 10% decline in SPX = 2,520 (-280 points) 1 SPX 2,520 October 19 th put (65 days away) = $12.30 or $1,230 1 SPX contract represents roughly $280,000 (2,800 x 100) 3 SPX contracts provides $840,000 equivalent protection (2,800 x 3 x 100) Action: Buy to Open 3 SPX 2,520 puts at a cost of $3,690 (12.30 x 3 x 100) or 0.43% of $850,000 portfolio 19
03 Index Hedging Example Expiration Scenarios for 2520 puts SPX % Change SPX Value Value of three SPX 2520 Puts Portfolio Value w/o Puts Portfolio Value w/puts Unhedged Portfolio % Change Hedged Portfolio % Change +5% 2940 $0.00 $892,500 $888,810 +5.00% +4.57% 0% 2800 $0.00 $850,000 $846,310 0% -0.43% -5% 2660 $0.00 $807,500 $803,810-5.00% -5.43% -10% 2520 $0.00 $765,000 $761,310-10.00% -10.43% -20% 2240 $84,000 $680,000 $760,310-20.00% -10.56% -30% 1960 $168,000 $595,000 $759,310-30.00% -10.67%
Let s review what we ve learned 1 2 3 4 Protect unrealized profits without selling holdings by purchasing index puts Choose the index that best correlates to your portfolio Decide how long you want the hedge, at what level, or strike, and how much you are willing to pay Calculate number of puts to purchase based on your portfolio value vs. index notional value 21
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