Try these option strategies to hedge your portfolio.

Modern Portfolio Theory tells us that the main driver of long-term returns is asset allocation, the mix between risky and risk-free assets.  Its purpose is to achieve the highest possible expected return with the lowest possible risk.

Asset allocation is foundational to risk management.  Nearly 94% of a portfolio’s return is attributable to its asset mix*.  Everything else – portfolio construction, security selection, periodic rebalancing – is peripheral.  Still, option hedging strategies can provide short-term relief from temporary volatility.

The market continues to trade near record highs, and for the time being, volatility has remained relatively tame.  If you are concerned that these two scenarios might change, then there are several options strategies you can employ to hedge against a market decline or a rise in volatility.

The approach you take will depend on your trading experience and sophistication, the approval level your broker has assigned your account, and whether or not you’re looking to create premium income.

There are two very straight forward techniques that can give you a short-term hedge.  They are a long put spread and a short call spread. Let’s review those first. Afterward, we’ll look at a couple more sophisticated structures.

The Long Put Spread

A long put spread is a straightforward debit spread (you’re paying premium) intended to profit if the price of the underlying security declines in value.  For this example, let’s use the proxy for the S&P 500, the SPDR S&P 500 ETF Trust (Symbol: SPY).

As I write this, SPY is trading at right around 320.  Let’s assume that you think the market could suffer a 2% decline in the next few weeks.  That would take it to about 314.

There’s some support at 316, so let’s use that as our short strike.  If we use today’s price of SPY as our long strike (320), then we’ve got a four-dollar spread that will cost us about $1.17.  That gives us a pretty decent risk to reward on the trade.

We lose the whole $1.17 if SPY is above 318.82 (that’s our breakeven) at expiration.  Anything below that and the trade is profitable.

The attractiveness of buying a spread instead of being long just the (higher, more expensive) at-the-money strike is that the sale of the lower strike option offsets the total price of the position.  You lower your risk because you pay less to accomplish the same hedge. Now let’s look at creating this hedge using calls.

Short Call Spread

A short call spread accomplishes the same objective as a long put spread.  It will become more profitable as the underlying declines in value.

We’re going to use the same fact pattern on this trade.  We’re still going to buy the higher strike and sell the lower one (long the 320, short the 316).  Of course, the really important difference in this scenario is that we’re using calls, not puts. Using the options montage above, we see that we’ll collect $2.82 in premium to open this position.

The risk to reward is the same on this trade as it is on the long put spread.  The breakeven price is the same. So is the profit probability. The performance graph looks the same as well.  There are two differences between these two trades (other than the type of options being used).

The first is that you’d be paying premium for the put spread, and you’d be receiving premium on the call spread.  The long put spread wouldn’t have an impact on your account’s equity position (margin). The short call spread, however would.  You’d tie up $400 of margin for each contract you sold.(This will vary by the margin requirements of your broker) So if things didn’t go as planned and if you didn’t manage your other trade positions carefully, then you could find yourself with a margin call.  So you want to be careful with any credit spread.

Hedging in General

As the two examples above illustrate, hedging against a decline in the market can be accomplished using either puts or calls.  We used the SPDR S&P 500 ETF Trust (SPY) to illustrate this. But market hedges can be affected using any index ETFs, including:

• QQQ – NASDAQ 100
• IWM – Russell 2000
• DIA – Dow Jones Industrials

Each of these ETFs have listed options.  The effectiveness of any one of them as a hedge would depend on the makeup of an investor’s specific holdings.  This is known as basis risk. Someone with a large concentration of tech stocks might use QQQ. Someone with exposure to mega cap stocks might use SPY or DIA.

There is an ETF for just about every industrial sector in the economy.  Most of them have listed options that can be used for hedging purposes. And, of course, there are listed options on thousands of individual stocks that can help one create a stock-specific hedge.  For investors looking to hedge market volatility, there are options on the VIX index.

To hedge an increase in market volatility, one could buy a call on the VIX or sell a put spread.  The VIX index rises as volatility increases, which normally means the market is declining. 

Two Sophisticated Hedges

Investors with greater experience trading options might also consider two other strategies to hedge a market decline or an increase in volatility.  The first approach is only appropriate for an investor with exposure to a given stock or index ETF. The strategy is known as a collar.

A collar is structured by selling an out-of-the-money call and using the proceeds to purchase an out-of-the-money put.  The trade limits the investor’s profit potential on the underlying’s appreciation beyond the short call. But the long put prevents the investor from suffering a catastrophic loss if the underlying has a precipitous decline.

The reason this structure should only be initiated by someone who is very experienced trading options and who is long the underlying security is that the short call in the collar is naked.  Unless the option writer owns the underlying, he or she is exposed to unlimited risk. And the long put does not offset that risk.

But for the investor who has enjoyed acceptable appreciation in the underlying, and is willing to reduce some or all of the holding risk if the short call is assigned, then a collar presents a very reasonable hedge.  In some cases, the proceeds from the short call can completely cover the cost of the put. When this is the case, then the investor has effectively created a risk-free hedge if the price of the underlying remains within the two different strikes.

Here’s what the risk/reward profile looks like on a covered collar.

Those with experience will notice that the profit and loss profile of a collar is very similar to that of a covered call.  The only difference is that the collar limits downside risk to the strike of the put. A covered call has the same downside risk of owning the underlying.

To hedge an increase in volatility, long exposure to the VIX index is the most straightforward strategy.  As noted above, one can gain that exposure by owning a VIX call option or a long call spread. An investor can create a synthetic long position by writing a VIX put spread or by entering into a risk reversal.

A risk reversal is created by buying an at-the-money call and selling an at-the-money put.  From a risk/reward perspective, a risk reversal behaves (at least until expiration) exactly the way a long position in an underlying security behaves.  It’s like buying the underlying outright, except that it costs less and ultimately expires.

Many times, the proceeds from sale of the put to completely offset the cost of buying the call. Volatility skew is the reason for this. Most option users are using them for hedges; therefore, implied volatility in the puts is generally more expensive than the calls.   Therefore, you can create a hedge at no upfront cost, and if there is a cost its generally minimal and requires less capital than buying the underlying outright.

With the market trading near record highs and relatively free from volatility, the strategies noted above could provide protection – and peace of mind – if things suddenly reverse direction.