How to Hedge in a Volatile Market

Most corrections and bear markets are caused either by "known unknowns" or "unknown unknowns." The former means we know when an event is going to occur; we just don't know what the result will be. Examples of these "known unknowns" are:

• US debt default
• Earnings reports
• Drug trial results or FDA panel reviews
• Economic reports
• Monetary policy decisions
• Election results

Other times, we don't know what will occur, when it will occur, or even if it will occur. These "unknown unknowns" are sometimes called Black Swan events and they may include:

• Merger and acquisition announcements
• Terrorist attacks
• Exchange malfunctions
• Most natural disasters
• Insider trading or financial fraud
• Bankruptcies and bank failures
• Pandemics

There's no hedging against a Black Swan, but you can sometimes spot a known unknown and hedge against it. Market declines usually begin as pullbacks (declines of <10%), turn into corrections (declines of >10% but <20%) and then finally become bear markets (declines >20%), so the bottom doesn't usually arrive immediately. Below, we'll review some strategies that you may be able to use both before and after the decline has started.

Before you make any moves, make sure you understand the following concepts:

• Volatility is a measure of movement, not a measure of direction. In the marketplace, however, volatility tends to drop when equity prices rise, and rise when equity prices drop, all else being equal.
• When the Cboe Volatility Index (VIX) is elevated, option prices in general (calls and puts) tend to be more expensive.
• Volatility manifests itself in the time value component of an option price. Since the intrinsic value (in-the-money amount), if any, is based entirely on the price of the underlying stock/ETF, only the time value changes when volatility changes.
• Spreads, collars and other strategies that involve an equal number of long and short options tend to neutralize much of the impact of volatility changes, allowing the focus to become strictly directional (based on price).
• Long options, or any multi-leg strategy involving more long options than short options, will generally work in your favor when volatility increases and against you when volatility decreases.
• Short options, or any multi-leg strategy involving more short options than long options, will generally work against you when volatility increases and in your favor when volatility decreases.
• With both calls and puts, the price change associated with a sharp price move in the underlying stock will often be partially or completely negated by a large change in volatility.
• Calls and puts generally decline in fairly equal amounts when volatility drops, and increase in fairly equal amounts when volatility rises.

With these factors in mind, let's review some strategies that may be useful during a correction or bear market:

Covered Calls (short calls/long stock)

In the early stages of a market decline, volatility may increase, which can make prices on covered calls more favorable. Selling covered calls can be a good strategy as long as you select a strike price at which you would be willing to allow your stock/ETF to be called away.

Advantages:

• Provides partial (but limited) downside protection
• Costs nothing to implement and can even generate a small amount of income
• Time value erosion could be beneficial when the underlying price is stable
• Timeframe is limited and the calls may eventually expire worthless

Disadvantages:

• Downside protection is limited to the amount of the option premium
• The upside profit potential is substantially limited
• If your short call options go in-the-money, you could be assigned at any time
• Stocks that pay dividends can be especially vulnerable to early assignment

Protective equity puts (long puts/long stock)

Advantages:

• Provides significant downside protection
• Has a defined exit price
• Offers potential protection even in a market that gaps down
• Does not require the underlying position to be sold
• Generally allows for unlimited upside profit potential

Disadvantages:

• Can be expensive
• Value erodes over time
• Timeframe is limited and the puts may eventually expire worthless

Collars (short calls/long puts/long stock)

Advantages:

• Can provide significant downside protection
• Has a defined exit price
• Might offer protection even in a market that gaps down
• Usually does not require the underlying position to be sold
• Can often be set up at little or no cost

Disadvantages:

• Substantially limits the upside profit potential
• If your short call options go in the money, you could be assigned at any time
• Stocks that pay dividends can be especially vulnerable to early assignment
• Timeframe is limited, as the options will eventually expire

Put spread collars (short calls / long puts / short lower strike puts / long stock)

Advantages:

• Can provide substantial downside protection for small downside moves
• Allows for greater upside potential than a traditional collar
• Usually does not require the underlying position to be sold
• Can often be done at little or no cost

Disadvantages:

• Downside losses can be substantial when there's a significant downside move
• Upside potential is still limited in the event of a significant upside move
• If your short call options are in the money, you could be assigned at any time
• Timeframe is limited and the puts may eventually expire worthless

Protective index puts (long index puts/long stock portfolio)

Advantages:

• Can provide significant downside protection for a diversified portfolio of equities
• Can provide protection even in a market that gaps down
• Cash settlement ensures that portfolio positions are never sold
• Often results in favorable (60/40) tax treatment

Disadvantages:

• Can be very expensive to use
• Requires a portfolio with a close correlation to an index that offers options trading
• Exact quantity required can be difficult to calculate
• Is usually more expensive during times of higher volatility
• Effectiveness can be reduced if volatility declines
• Value erodes over time
• Timeframe is limited and the puts may eventually expire worthless

As you can see, each of the many ways to hedge against adverse market movements involves tradeoffs. Consider focusing only on those positions in your portfolio that are historically the most volatile or those that make up a substantial position of your account.