How to hedge better using stock options

  • By Harrison Cole

  • June 20, 2018
  • 1:37 am BST

In mid-May of 2018, to insure yourself against equity risk with a one-month S&P 500 Index put option at-the-money, the premium was about 1.5%. Before that, it was in the 2.0% to 2.5% range. If this were to persist consistently, you’d pay 18% to 30% to maintain that exposure for a year. That is not to say that options, CFD trading and forex trading do not come with their own inherent set of risks anyway. But if there isn’t a sell-off, trading pros believe those writing put options are undeniably seeing substantial profits by providing such insurance.

It’s easy to understand why investors would want to buy protection or hedge the ‘tail risk’ in equity portfolios now, given the post-2008 gains. But, as any good investor also knows, gains cannot be sustained forever, and it seems sentiment has now shifted to protecting those profits and funding levels.

Yes, there are currently a number of options and CFD trading strategies that are likely to work. However, a program based on buying put options as a tail-risk hedging strategy can be an ineffective, expensive and downright dangerous way of doing so long term.

No cost-effective option

There are three insurance protection types for put options, with none of them being particularly effective or, at the very least, cost-effective.

  1. Selling call options, or creating ‘put spreads’. Purchasing puts at various strike prices to help finance costly puts are a hedging solution that is not a solution at all – just a new problem that has to be negotiated.
  2. Setting aside a smaller budget towards this and resigning yourself to a smaller portion of the equity-portfolio value will be covered in principle by the insurance – this does not really change your long-term investing outcome for the better.
  3. Choosing out-of-the-money puts, leaving your portfolio vulnerable to any initial market sell-off until the index drops below the option strike prices – again, this does not really change your long-term investing outcome for the better.

Out-of-the-money put or a more restricted hedge budget?

Any pro who does the calculations properly will clearly find that you cannot justify the costs of the long-term results of a tail-risk hedging program that rests on buying puts. But, you could argue, no one does this anyway for extended periods.

To get it right tactically, it is therefore all about timing. You need to:

  • Buy put options before a big sell-off occurs.
  • Sell them before they expire or cross back out-of-the-money.

Which begs the question, why use options at all if you can do this? Simply reduce or increase risk tactically to get around the thorny insurance issue. The fact is, long-dated puts are of no avail either.

If you are unlikely to get the timing right, stay away – it’s expensive to maintain put option positions. This should hardly come as a surprise, as equity markets do tend to move upwards long term.

You can overcome down markets with options and CFD strategies – in fact, there are seven specific CFD strategies you can use or adopt for this year alone. But buying and holding short or long-dated, at-the-money or out-of-the-money put options are simply not ‘options’. Yes, in any given year, a hedging strategy using long-dated or short-dated options can and may outstrip the performance of the S&P 500. But, over longer periods, you can hedge your money on this: option markets will not be going out of their way to make a loss on selling you insurance. Portfolio insurance is still insurance, and such services are not designed to lose money by selling cover – just like their colleagues in the medical, automobile or housing insurance fields.