Using S&P 500 Put Options to Hedge a Downturn

Long-term portfolios are designed to be just that: long term. Selling a position as a reaction to market pullbacks may seem like a good idea, but it may lead to missed opportunities from improper market timing and losses from capital gains taxation.

There's a different option—literally. Buying protective puts on the S&P 500^® index (SPX) is just one way investors can try to protect their portfolios against expected market downturns. These index options are cash-settled, highly liquid, and cover a broad swath of the U.S. stock market.

The downside is that put options contracts carry a premium. The more volatile the market, the higher the premium. In many circumstances, though, investors will find the degree of protection to be worth the money.

It's important to understand that portfolio hedging is an advanced topic, so investors considering this strategy should have experience using options and be familiar with the risks and the potential benefits before implementing this strategy. Investors still learning about options can find more introductory content at schwab.com/learn.

Investors pay a premium to set up a protective put position. The size of the position depends on how much of the portfolio they want to hedge. Hedging all of it is a lot more expensive than hedging part of it. The hedge also needs to protect the portfolio effectively. A hedge using S&P 500 puts will be less effective against an international portfolio than a portfolio of U.S. large-cap stocks that would likely better mirror the S&P.

A portfolio hedge could be considered effective if the value of the hedged portfolio holds relatively steady in the face of dropping asset prices. When trying to hedge an equity portfolio against a market sell-off, the hedge would be effective if it appreciates in value, or offsets some or all of the drop in equity prices. For example, if a trader strongly believes the stock market has the potential to fall 5% to 8% over the next three months, an effective hedging strategy that costs less than 5% of their total portfolio's value may be worth considering.

Let's say a trader holds an equity portfolio worth $1 million that's highly correlated with the SPX and they're concerned the index may sell off substantially over the next three months. The trader is willing to spend approximately 2% of the total portfolio value—or $20,000—to hedge the portfolio over that time.

Assume the SPX is at 6,000 and the Cboe Volatility Index^® (VIX)—the average 30-day implied volatility based on a basket of short-term SPX options—is at roughly 17. For this example, the trader is using out-of-the-money (OTM) options to obtain temporary downside protection in the event of a sell-off. The cost of an OTM SPX put option at the 5,710-strike is $10,000.

With the $20,000 they've allocated for hedging, the trader could potentially buy two OTM SPX 5,710-strike put options for a total of $20,000: $100 (ask) x 2 (# of contracts) x 100 (options multiplier) = $20,000 (excluding transaction costs).

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

As seen above, the hedged portfolio maintained much of its value during the various SPX sell-off scenarios, but it underperformed the unhedged portfolio in the +5%, 0%, and –5% scenarios due to the cost of the protection strategy. Some investors will appreciate having the hedge in place, despite the cost.

• The above example assumes that the SPX puts are held until expiration (approximately three months), but keep in mind, a trader can probably sell the puts before they expire if they feel like the hedge is no longer necessary. Most index puts are European style, so they cannot be executed early, but there could still be a market for them; selling a put isn't the same as exercising it. If the trader sells the put, they'll likely capture some of the time value remaining in the puts, which would lower the initial 2% hedging cost.  
• If the VIX's level had been lower at the time the puts were purchased, the hedge would've been less expensive because hedging costs rise in line with increased options premiums due to higher volatility expectations. Therefore, if the trader waited for the market to settle down, there's a high probability that the VIX could move below 17 to make the equivalent hedging strategy cost less.  
• The converse is also true: If the VIX had been above 17, the equivalent hedge would likely cost more. Keep in mind, the VIX tracks a 30-day estimate of the implied volatility of a basket of SPX options and the implied volatility on a specific contract (such as the OTM put referenced in the example above) can be higher or lower than the VIX's value.  
• If the trader feels that 2% of their portfolio's total value is too much to spend on a hedging strategy, they may consider selling covered calls on some of the individual equity positions in the portfolio to help offset the cost. (Keep in mind, this places those positions at risk of being "called away," which can happen at any time throughout the life of the short option.) Because the trader in the above example purchased puts on an index they don't (and can't) own, they can't sell calls on that index without establishing a naked call position, which involves substantial risk and requires an account approved for more advanced options strategies. If a trader is not comfortable selling calls on their existing stock positions and are still concerned with the cost to hedge, then buying index puts for portfolio protection may not be appropriate for them either.
• The IRS considers profits from index options to be a mix of short-term and long-term gains, which may cause some unpredictability at the end of the year due to mark-to-market rules.

The hedging strategy presented above provides a 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 a hedged portfolio is being down 6.8% for the next three months. Others may want more coverage and be willing to pay for protection against smaller declines. Still, others may feel that the cost is too high or establishing a short-term hedge is equivalent to timing the market and, therefore, may elect to focus on the long term.

The cost of a protective index put option is higher the more likely it is that it will be needed. Investors need to assess their own risk tolerance and comfort with the market outlook before buying protection against a downturn.