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How To Properly Hedge Your Portfolio Using Put Options
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The public equity market is trading very precariously, with peak earnings growth, ultra-low interest rates, peak consumer demand, and accommodative monetary/fiscal policies, all now ostensibly in the rearview mirror. As we enter post-earnings season action, market participants are taking on a 'this is as good as it gets' mentality.
We are entering a period of season weakness (mid-August to mid-October) where volatility spikes are common, and market participants typically rotate profits over to defensive sectors: consumer staples, health care, and utilities.
It may be time to think about hedging your portfolio against broader market risks with put options.
How To Hege With Options
First, the number of put contracts you buy depends on how hedged you want to be with your portfolio. This is somewhat of a complicated trade, so I would always err on the side of caution. Remember, each put option on SPY represents the option to sell 100 shares of SPY. We figure out how to hedge a 100k portfolio tracking the S&P 500, for example, by taking each 100-share option contract and dividing it by that contract's delta.
For example, a SPY Sept. 17 put contract with a strike price of $430 has a delta of (-0.37), meaning that every dollar that SPY falls reflects a $37 price increase for this contract (0.37*100 shares). Keep in mind that as the price of SPY changes, the delta of all 'near-the-money' options changes with it. As you get closer to the money/deeper in the money (SPY comes closer to $430 or below for this example), your delta will go up along with the option's value. The speed at which delta changes is called gamma, which increases as you come closer to expiration.
Now to figure out how many contracts you want to purchase to hedge your entire portfolio, you're going to need to do some math. It is essential to understand how to fully hedge your portfolio, something you do not want to do but must calculate to find a suitable number of contracts for your hedge.
The Calculation
To fully hedge a 100K portfolio at the aforementioned strike & expiration, you would need 100,000/439 (the value of SPY)/100 (shares in each contract)/0.37 (delta)=roughly 6 contracts. In this scenario, you would trade in/out of put contracts as the delta, and the SPY price moves up or down (just plug and chug into this equation). The equitation is put more clearly below:
Image Source: Daniel Laboe
As I said, you don't want to fully hedge your portfolio because that effectively means you would trade sideways (assuming you are buying/selling options to reflect changes in delta). The approach I would take is to take that full hedge, divide it by 2 or 3 or even 4 and use that figure as the number of contracts to purchase.
Final Thoughts
Ensure that your puts are reflective of your portfolio. If your well diversified across sectors, SPY is a good conduit, but if you are heavy in blue-chip tech, QQQ may be a better ETF to utilize.
Keep in mind that this is just option protection, so you have to be fully willing to lose the option's premium (the price of the option). That being said, at the current frothy market levels we're trading at, going into this highly uncertain earnings season and implied volatility being relatively low: this is a smart move.
Don't hold these things till expiration but rather scale out of them as the price moves down, and you can even buy more as the ETF's price moves up (only do this if you are willing to put on more risk). If you don't feel comfortable with options, then I would suggest you stay away.
Image: Bigstock
How To Properly Hedge Your Portfolio Using Put Options
The public equity market is trading very precariously, with peak earnings growth, ultra-low interest rates, peak consumer demand, and accommodative monetary/fiscal policies, all now ostensibly in the rearview mirror. As we enter post-earnings season action, market participants are taking on a 'this is as good as it gets' mentality.
We are entering a period of season weakness (mid-August to mid-October) where volatility spikes are common, and market participants typically rotate profits over to defensive sectors: consumer staples, health care, and utilities.
It may be time to think about hedging your portfolio against broader market risks with put options.
How To Hege With Options
First, the number of put contracts you buy depends on how hedged you want to be with your portfolio. This is somewhat of a complicated trade, so I would always err on the side of caution. Remember, each put option on SPY represents the option to sell 100 shares of SPY. We figure out how to hedge a 100k portfolio tracking the S&P 500, for example, by taking each 100-share option contract and dividing it by that contract's delta.
For example, a SPY Sept. 17 put contract with a strike price of $430 has a delta of (-0.37), meaning that every dollar that SPY falls reflects a $37 price increase for this contract (0.37*100 shares). Keep in mind that as the price of SPY changes, the delta of all 'near-the-money' options changes with it. As you get closer to the money/deeper in the money (SPY comes closer to $430 or below for this example), your delta will go up along with the option's value. The speed at which delta changes is called gamma, which increases as you come closer to expiration.
Now to figure out how many contracts you want to purchase to hedge your entire portfolio, you're going to need to do some math. It is essential to understand how to fully hedge your portfolio, something you do not want to do but must calculate to find a suitable number of contracts for your hedge.
The Calculation
To fully hedge a 100K portfolio at the aforementioned strike & expiration, you would need 100,000/439 (the value of SPY)/100 (shares in each contract)/0.37 (delta)=roughly 6 contracts. In this scenario, you would trade in/out of put contracts as the delta, and the SPY price moves up or down (just plug and chug into this equation). The equitation is put more clearly below:
Image Source: Daniel Laboe
As I said, you don't want to fully hedge your portfolio because that effectively means you would trade sideways (assuming you are buying/selling options to reflect changes in delta). The approach I would take is to take that full hedge, divide it by 2 or 3 or even 4 and use that figure as the number of contracts to purchase.
Final Thoughts
Ensure that your puts are reflective of your portfolio. If your well diversified across sectors, SPY is a good conduit, but if you are heavy in blue-chip tech, QQQ may be a better ETF to utilize.
Keep in mind that this is just option protection, so you have to be fully willing to lose the option's premium (the price of the option). That being said, at the current frothy market levels we're trading at, going into this highly uncertain earnings season and implied volatility being relatively low: this is a smart move.
Don't hold these things till expiration but rather scale out of them as the price moves down, and you can even buy more as the ETF's price moves up (only do this if you are willing to put on more risk). If you don't feel comfortable with options, then I would suggest you stay away.
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