How to Hedge Against an Event-Driven Market Correction

Sometimes it's difficult to accept, but investing in stocks means that volatility and market corrections will occur. Sometimes you can see it coming and sometimes it takes everyone by surprise. If you're convinced that a major developing event either on or off Wall Street could cause a significant market sell-off in the near future, it may be time to consider how to hedge your portfolio.

Hedging strategies are designed to reduce the impact of short-term corrections in asset prices. For example, if you wanted to hedge a long stock position, you could buy a put option or establish a collar on that stock.

These strategies can often work for single stock positions. But what if you're trying to reduce the risk of an entire portfolio?

A well-diversified portfolio generally consists of multiple asset classes with many positions. If you wanted to hedge the equity portion of your portfolio, you'd have to hedge every equity position—which would be extremely costly.

Here, we'll look at how to deploy a portfolio hedge with a focus on S&P 500^® Index ($SPX) put options. It's important to understand that portfolio hedging is a fairly advanced topic, so investors considering this strategy should have experience using options and be familiar with the trade-offs they involve. 

Effectiveness and cost are the two most important considerations when setting up a hedge.

A portfolio hedge would be considered effective if its value holds relatively steady in the face of dropping asset prices. If we're trying to hedge an equity portfolio against a market sell-off, we would expect the hedge to appreciate in value so that it offsets the drop in equity prices.

As for cost, how much would you be willing to pay to hedge your entire portfolio for a certain period of time? That may depend on what you think the market might do in the near future. For example, if you strongly believe the stock market will fall 5%–8% over the next three months, an effective hedging strategy that costs less than 5% of your total portfolio's value may be worth consideration.

Finding a single financial product to hedge your entire portfolio in all its uniqueness could be a challenge. But if you have a well-diversified equity portfolio, S&P 500 ($SPX) put options could be an effective hedging product.

Options on the S&P 500 Index are considered "1256 contracts" under tax law and offer the following benefits:

• Favorable tax treatment: Many broad-based index options qualify for 60% long-term/40% short-term capital gains treatment—meaning 60% of your gains are taxed at the lower long-term capital gains rate, while just 40% is taxed as regular income. Other broad-based index options that qualify include those that overlay the Dow Jones Industrial Average ($DJX), Russell 2000 Index ($RUT), and NASDAQ 100 ($NDX).
• Cash settlement: All index options are cash settled, which makes the position easier to manage around expiration.
• Leverage: $SPX put options have a 100 multiplier, which provides the potential to offset a substantial decline in the portfolio for a relatively small upfront cost.¹ 

Let's say you own a $1,000,000 equity portfolio that is highly correlated with the S&P 500 and you're concerned that the S&P 500 may sell off substantially over the next three months. You're willing to spend approximately 3% of the total portfolio value—or ~$30,000—to hedge your portfolio over that time (more on this below).

Assume the SPX is at 4,150 and the Cboe Volatility Index (VIX)—the average implied volatility of SPX options—is at ~17. The cost of one SPX 4,150 put option that expires in approximately three months is $10,900 ($109 ask price x 100 multiplier, excluding commissions).

For this example, we're using the at-the-money strike price to obtain immediate downside protection in the event of a sell-off. With the ~$30,000 you've allocated for hedging, you could buy three SPX 4,150-strike put options for $32,700: $109 (ask) x 3 (# of contracts) x 100 (option multiplier) = $32,700 (excluding commissions).

The table below shows how hedging would affect your portfolio value upon the expiration of the three-month SPX put options.

As you can see in the example above, not only did the hedged portfolio maintain its value during the various SPX sell-off scenarios, but it actually resulted in a net profit for the overall portfolio in the –15% and –20% scenarios. However, in the first two scenarios where the S&P does not sell off (+5%, 0%), you can see that the hedged portfolio underperformed the unhedged portfolio due to the cost of protection.

Additional considerations:

• The above example assumes that the SPX puts are held until expiration (approximately three months), but keep in mind that you can sell the puts before they expire if you feel like the hedge isn't necessary any longer. If you do, you'll likely capture some of the time value remaining in the puts, which would lower the initial 3% hedging cost. 
• If the VIX's level had been higher, the hedge would've been more expensive, given that hedging costs rise in line with increased volatility expectations. Therefore, if you wait for the market to sell off, there's a high probability that the VIX could move above 17. This would cause three-month at-the-money options to be more expensive, resulting in higher put prices and making the equivalent hedging strategy cost more than ~3%. The converse is also true: If the VIX had been below 17, the equivalent hedge would've cost less than 3%. 
• If you feel that 3% of the total value of your portfolio is too much to spend on a hedging strategy, you may want to consider selling covered calls on some of the individual equity positions in your portfolio to help offset the cost. Because we purchased puts on an index that we don't (and can't) own, we can't sell calls on that index without establishing a naked call position. If you're not comfortable with selling calls on your stocks, and you're still concerned with the cost, then this strategy may not be appropriate for you.

The hedging strategy presented above provides an efficient way to hedge an entire portfolio, but is the cost worth the benefit? Some investors may take comfort in knowing that the "worst-case scenario" for their portfolio is being down ~3% for the next three months. Others may feel that establishing a short-term hedge is equivalent to timing the market and, therefore, may elect to focus on the long term.

Regardless of your opinion, gauging the likelihood of a significant market decline may be helpful.