Portfolio Hedging using Index Options Explained

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Using VIX Options to Hedge Your Portfolio

According to CBOE, The CBOE Volatility Index® (VIX® Index®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the VIX Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.

Introduction

Several investors expressed interest in trading instruments related to the market’s expectation of future volatility, and so VIX futures were introduced in 2004, and VIX options were introduced in 2006.

Options and futures on volatility indexes are available for investors who wish to explore the use of instruments that might have the potential to diversify portfolios in times of market stress.

VIX is a great way to hedge your long portfolio. It is a well known fact that during severe market downturns, VIX spikes significantly, which can offset some of your portfolio losses. However, you cannot trade VIX directly. There are few ways to trade VIX:

Of course if you buy VIX calls and volatility spikes, you can make some significant gains. But most of the time, those calls will lose money due to the fact that VIX drift lower, and those options will lose value over time.

Possible solution: VIX strangle

This article describes the following strategy of going long VIX:

  1. Purchase VIX put options that expire 3 months out and are 2.5% out of the money and simultaneously buy 4th month call options that are 20% out of the money. These positions are established each month on a date that is half way between the 3rd and 4th month expiration dates. Two months later these option positions are rolled.
  2. The put leg of the calendar strangle can help reduce the cost of the long call. Typically, when hedging through purchasing an out of the money call option on VIX to gain protection against tail risk there can be an undesirable carrying cost for the position. In periods of low volatility the long put position will benefit from the term structure of VIX futures pricing as the time to expiration for the option approached expiration. The long call position will be in place to potentially benefit from market conditions that result high higher implied volatility for the market as indicated by VIX.

The general idea is that short term futures are declining faster than long term futures, and if VIX stays stable, the put gains will offset the call losses. Basically the strategy will roll the trade every two months.

Expected results

During calm periods when VIX stays stable or drifts lower, we can expect the trade to produce 10-15% gains or end up around breakeven because the puts gains will offset or slightly outpace the calls losses.

However, during periods of volatility spike, the calls should gain significantly, and in some cases, the whole structure can deliver 50-100% gains. This is basically a cheap way to go long VIX and hedge your long portfolio, without experiencing losses during calm periods.

We have made several changes to the strategy in order to better adapt to the current market conditions.

Want to see how we implement this strategy in our SteadyOptions model portfolio?

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    Portfolio Hedging using Index Options Explained

    If you’re an investor, especially one who believes in buy-and-hold methods, then you should learn about using hedging to your advantage. Portfolio protection through hedging is essential, especially when stocks start crashing. That said, you can use options to protect single stock positions or your entire portfolio.

    If you’re new to the world of trading, learning the basics of hedging should be at the top of your to-do list. But even experienced traders can always use a recap in the powers of hedging strategies. Here’s a quick, in-depth look into what hedging can do for you:

    What is Hedging?

    The reason investors hedge is because they want insurance against a stock market collapse. Using hedging strategies is an intelligent way to protect your livelihood as a trader, and your assets.

    When trying to grasp the concept of hedging, think of healthcare.

    For example, when you buy insurance, you pay a premium for a certain level of protection. For example, healthcare insurance can vary in price and coverage. Hedging works in a similar way — it’s a premium you pay for the protection of your trades. That said, hedging isn’t always about protecting your portfolio against a black swan event. You may want to hedge against an unknown outcome like an earnings event or other known catalysts.

    Hedging Methods

    There are several ways a trader can hedge their portfolio. Let’s examine some of the more common methods.

    1. Options. One of the fastest and easiest ways to hedge your stock exposure is by buying puts. A put option acts as a built-in stop loss. When you purchase a put option, you are paying a premium for stock protection. Hedging with options is a great way to reduce the risks involved with making the purchase, but it also reduces your potential profit.

    2. Stocks. This can be achieved by trading inverse-ETFs and volatility ETNs. However, for the average investor, trading those instruments are complex and potentially too risky. That said, I primarily stick to options trading because they offer a number of benefits.

    Benefits of Options

    1. You don’t need a large trading account.

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    2. You can define your risk.

    3. Leverage. For as little as $500, you can control 100 shares of some of the largest companies in the world.

    4. Potential for fast cash. You just need to see small stock moves to make big bucks with options because of leverage.

    However, when you’re hedging, you’re thinking defense, not offense. Hedging is an expense, just like most other forms of insurance.

    Option Hedging Strategies

    As previously mentioned, the fastest and easiest way to hedge is by buying put options. However, if you’re new to options, an options chain can be overwhelming. For example, answering questions like “Which strike should I buy?” can be overwhelming. Not to mention all the different expiration periods there are to choose from. That said, let’s look at the different levels of protection different put options offer.

    Hedging Examples

    In this example, a trader is looking to hedge against a known catalyst, Apple Inc.’s Q4 2020 earnings release:

    Above, you’ll see an option chain of Apple Inc, hours before it announces its earnings results. That said, options are priced rich because of the catalyst.

    Out-of-the-money Options

    Apple’s stock price is trading at $155.17 per share.

    The $150 put options that are expiring in three days are trading for $2.37. What level of protection does that give you?

    To figure out the break-even level, you’ll take the strike price and subtract it by the premium of the put option. In this case, it’s $147.63.

    Now, those same strike options, $150 puts, trade for $4.10 for the contracts that expire 31 days from now. Your break-even mark is $145.90. If you go out further, say 79 days out, those same $150 puts trade for about $5.90.

    Lesson: The farther you go out, generally speaking, the more expensive options will be. Also, the higher the implied volatility, the more expensive options will cost.

    At-the-money Options

    At-the-money, or ATM, options refer to the strike price that is closest to what the stock is trading at. In the example above, it would be the $155 puts.

    They are valued at $4.35 with 3 days till expiration. In other words, if you are long on the stock, and you hedge with ATM puts, you’re liable for only about 3% of downside.

    In-the-money Options

    The $160 put strike would be an example of a put option that is in-the-money, or ITM. The option has a value of 7.10. However, if you subtract $160 from the stock price, this option has almost $5 of intrinsic value. That said, it offers more protection than the $150 and $155 puts.

    Hedging For The Worst

    Options are at their most expensive ahead of a catalyst. However, after the outcome of the event is known, option premiums deflate. That said, that is the best time to put on long-term hedges. If you have a basket of stocks, a diversified portfolio, then you might want to consider exploring hedging with index options or ETFs. For example, buying puts in the SPY, IWM, DIA, or QQQ might be a sufficient hedging strategy if your portfolio resembles them enough. Furthermore, industry-specific ETFs could be another way to implement a hedging strategy. For example, SPDR has ETFs for energy, health care, technology, utilities, and much more.

    If you fear the worst, consider hedging with deep out-of-the-money put options. These are options that are very low in premium and have a low probability chance of ever being profitable. However, for hedging purposes, it doesn’t offer you much near or medium-term protection. But it could save you some money if there is a sizeable premarket move lower.

    Final Summary

    Sophisticated investors can use stocks to hedge. Pairs trading is a strategy some professionals use. For example, let’s say you thought one stock was going to outperform the sector. So you might consider buying JPMorgan Chase and shorting a financial ETF that includes all the top banks.

    As you can see, while this strategy might sound appealing to the professional, it’s too complicated and expensive for most retail traders. That’s where hedging with options comes in. Using options as a way to hedge is easy and can save you some money.

    If you’d like to know more about becoming a better options trader, make sure to read my latest eBook, 30 days to options trading. My goal is to give you the resources you need to become a successful options trader. Put options, call options, hedging strategies, and more — you’ll be that much closer to trading success after reading your free copy of my eBook.

    One of the best traders anywhere, over the past 20 years Jeff’s made multi-millions trading stocks, ETFs, and options. He is renowned as an incredible trader with a deep insight and a sensitive pulse on the markets and the economy. Jeff Bishop is CEO and Co-Founder of RagingBull.com.

    Even greater than his prowess as a trader is his skill and passion in teaching others how to trade and rake in profits while managing risk.

    Index Options

    What are Index Options?

    The index option is a derivative instrument that tracks performances of the entire index and gives the right to buy (or sell) units of an index at a contracted rate on a certain future date. Dow Jones Index Option is one such example, where the underlying is based on 1/100th of the DJIA index and the multiplier is $100.

    Most common examples of index options include (but are not restricted to):

    • S&P 500 and SPX
    • DJX – Dow Jones Index
    • IWB – iShares Russell 1000® Index Fund
    • NDX – Nasdaq-100
    • OEX – SP100 Index
    • QQQ – Options on Nasdaq-100 Index Tracking Stock
    • RMN – Mini-Russell 2000®
    • RVX – CBOE Russell 2000® Volatility Index Options Index

    Components and Types of Index options

    Just like any vanilla option, Index options are characterized by:

    • An underlying index
    • The strike price of the option
    • The maturity/ expiry date of the option
    • Whether it’s a put or a call option

    The underlying index is what differentiates one option from others, e.g. an option contract on S&P 500 will give an option buyer the right to buy (or sell) certain units (as earlier agreed upon in the contract) of S&P index and the option writer will have to sell (or buy). Index options may have broad-based indices such as S&P or the Dow Jones or may have sector-specific indices which focus on industries like Information technology, healthcare, banking, etc. e.g. TSX composite bank index.

    Index Option Example with Calculations

    #1 – Pricing of an Index Option

    Option pricing is the first and ideally the most complex one to do. Pricing means what premium an option buyer is required to pay upfront to assume the rights to buy (or sell). Option Premium theoretically can be calculated using replicating portfolio, using hedge ratios and binomial trees but more advanced methods like Black Scholes Merton pricing formula, Vanna Volga pricing, etc. are used in Financial Markets.

    The premium paid by option buyer is calculated using various methods. The common inputs for Option Premium calculations are Current Spot Price, Strike Price, Days to expiry, Volatility of Stock price, Risk-free rate of return, dividends if any, etc.

    The Black Scholes Merton pricing formula is expressed as below:

    • c: Premium/ price of the call option
    • p: Premium/ price of the put option
    • S0:Spot price
    • K: Strike price
    • N(d1): Probability distribution of Spot (Delta of the option)
    • N(d2): Probability distribution of forward price movement
    • T: time to expiry
    • r: Risk-free rate of return
    • σ:Estimated volatility

    Vanna-Volga pricing model takes BSM one step further and adjusts the above formula for risks associated with volatility.

    The main problem associated with the above models in pricing the index options is how to account for the dividends associated with different stocks in the basket of the index. To estimate the dividend component, individual stock’s dividend needs to be ascertained and weight them in proportion to each stock in the index. Another way is to use dividend yield published by data sources like Bloomberg.

    #2 – Valuation or Mark to Market of an Ongoing Option Contract

    The Value of Call Option to the buyer (Or seller) after the contract till expiry keeps on changing. Depending on that, either of the party can terminate the options contract by paying cancellation charges as agreed by both parties.

    The calculation involved in Valuation is similar to the pricing of the option. Parameters such as volatility, time to expiry risk-free rate of return keeps on changing depending on how financial markets are working.

    #3 – Payoff Calculation

    Assume, Firm A need to invest in the Dow Jones index (DJX) after 1 month. Currently, Dow Jones trades at $267. Firm A is bullish on Dow Jones and believes the DJX will trade at $290 basis the analysis on financial data in the market. Another Firm B is mildly bearish on the DJX and believes DJX will stay below $265.

    The two firms will then formally enter into a Call option Contract with Strike Price of $265 and maturity of 1 month.

    • Firm A will be long on Call option contract and thus will have the right to buy units of DJX from Firm B at a price of $265, even if the Shares of ABC are trading at $290.
    • To get this right to buy, Firm A will have to pay some upfront amount known as Option Premium.
    • Firm A will not be obliged to buy units of DJX if the price is less than the strike price of $265, thereby having downside risk protection.
    • Firm B will be short on Call option contract and will have to sell the units of DJX irrespective of what rate DJX is trading at.
    • The contract expires after fixed expiry date i.e. 1 Month

    Advantages of Index options

    Following are the advantages of these options.

    • Diversification: Index options are based on a large basket of stocks. This gives an easy diversification alternative to the investors.
    • Volatility: Index options are less volatile, hence easier to predict
    • Liquidity: Since Index options are popular among traders, hedge funds and investment firms, the volume available for trading is enough to keep the bid-ask spread in check and prices are very close to a fair price.
    • Cash Settlements: Index options are cash settled. This makes settlements easier as opposed to the actual delivery of stocks in stock options
    • Relatively low-cost investment alternative than to buy individual stock options

    Disadvantages of Index Options

    Below are the limitations of Index options.

    • Index option being little less rewarding may not be attractive for investors who are willing to take on higher risks for more rewards
    • The pricing models for options are very complex and to account for underlying like indices, it becomes way too complex to price

    Conclusion

    Index options can be used for hedging a portfolio of individual stocks or for speculating the future movement of the index. Investors can implement various option trading strategies with index options viz. Bull spreads, bear spreads, covered calls, protective puts. These strategies may lead to lesser profits but the risk is minimized greatly.

    This has been a guide to What is Index Options and its definition. Here we discuss the types of index options, how it is priced along with calculation examples, advantages, and disadvantages. You can learn more about derivatives from the following articles –

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