Managing Risk with Put Options
by Eric ChamberlainJuly 05, 2012 | Comments : 0 Recommended this article: (0)
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When you start down the path of trading stocks, you are introduced to many catch phrases that are considered to be sacred truths in the investment community. These include phases like: "buy low, sell high", "cut your losses short and let your winners run", "plan your trade and trade your plan", and "never trade without stop loss orders". While all of these are wise words to follow, I would like to focus on the last one, "never trade without stop loss orders", and give you an alternative interpretation that may open some new management options for you.
On the surface, stop loss orders seem like a simple and logical approach for minimizing risk. The idea seems simple enough. Place a sell stop order below the purchase price to minimize risk. I, like many traders, have had the experience of seeing the stock retreat to my stop price, or just below, and then reverse course and zoom off into the stratosphere. What might have been a profitable trade instead turns into a loss.
Is there a better approach for minimizing risk? Well, I've been trading long enough to know that there is no such thing as the "best" approach to anything, but certain methods work better than others depending on your personal trading style. Here is an approach I have witnessed institutional traders apply to stock portfolios. You too might find it useful for hedging your small-cap and mid-cap stock portfolio.
Stop loss orders are meant to help traders and investors manage risk when they are not able to be physically present to monitor their portfolios themselves. Instead of using stop loss orders, particularly when you are trading thinly traded small-cap and mid-cap stocks, you may want to consider using a hedging strategy known as "Beta-Weighting" instead.
For simplicity, let's create a large portfolio of all the current Zacks #1 Rank ('strong buy') stocks. In the Research Wizard, I'll run a screen for all the Zacks #1 Rank stocks 233 stocks appear. Next, I'll calculate the beta for the portfolio. Although, this step may sound difficult, it is nevertheless quite simple in the Research Wizard. Simply add the beta to the report definition window. (see below)
Let's assume an equal amount of money is allocated to each position, therefore, the average beta for the portfolio is 1.12.
The Beta Coefficient is a means of measuring the volatility of a security or of an investing portfolio of securities in comparison with the market as a whole. In other words, Beta is measuring the sensitivity of a stock's or portfolio's return to the return on some market index, e.g., the Russell 2000.
Beta is calculated using regression analysis. A Beta of 1.0 or 100% indicates that the security's price will move with the market. A Beta greater than 1.0 indicates that the security's price will be more volatile than the market. Finally, a Beta less than 1.0 means that it will be less volatile than the market.
Our portfolio's average beta was 1.12 or 112%; therefore, the portfolio is 112% as volatile as the market (Russell 2000). For instance, if the market moves up by 10%, the portfolio should move up by 11.2% (.10*1.12). Likewise, if the market falls by 10%, the portfolio will likely fall by 11.2%.
One word of caution about betas is in order. Although these concepts are logical, the entire theory is based on past data. Thus, the betas we calculate show how volatile a stock has been in the past, but conditions may change and its future volatility may rise or fall.
After we've determined the portfolio's average beta, we can proceed to calculate the hedge ratio, i.e., the number of put options needed to protect the portfolio against a landslide in the market. For those of you new to hedging techniques, think of a put hedge as a type of insurance policy for the entire portfolio. Assume we are willing to accept a 20% correction.
Step 1) Calculate the number of put options needed without using beta coefficient
Portfolio Value: $100,000
Russell Index (RUT): 713.58
Portfolio Risk (20%): 713.58 * (1-.20) = 570.86
June 570 Puts: $2.50
Portfolio Value $100,000 / Index 713.58 = 140.13 or 1.4 puts
Step 2) Adjust the hedge ratio for the sensitivity of the portfolio
1.4 put contracts * 1.12 beta = 1.6 rounded up to 2 contracts
Step 3) What is the total cost of insurance?
2 put contracts * $250 per contract = $500
Note a higher number of puts options needed to hedge the portfolio. This is logical, since a beta greater than 1.0 or 100% is more sensitive and more risky than the market (Russell 2000).
When implementing this strategy, remember that beta of a portfolio is not static but rather dynamic, i.e., it will change over time. You may need to check betas regularly to ensure your hedge ratio reflects the sensitivity of the portfolio. Adjusting your hedge, however, may require additional brokerage fees.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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