How to Hedge Against an Event-Driven Correction

Sometimes it's difficult to accept, but investing in stocks generally comes with periodic market corrections along with weathering periods of higher volatility. Sometimes you can see a market correction 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 ways to hedge your stock portfolio.

Hedging strategies are designed to reduce the impact of short-term corrections in asset prices. For example, if a trader wants to hedge a long stock position, they could buy a put option or establish a collar on that stock. Buying the put option would temporarily lock in a price below the current stock price at which the trader could sell the stock. A collar (a long put and a short call) would allow the trader to set a price target above the current stock price where they're willing to sell.

These strategies can often work for single stock positions. But if a trader is trying to reduce the risk of an entire portfolio, it can involve additional commissions and position management around expiration.

A well-diversified portfolio generally consists of multiple asset classes with many positions. If a trader wanted to hedge the equity portion of their portfolio, they'd have to hedge every equity position—which could be costly and time consuming if the portfolio holds many individual stocks.

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 an advanced topic, so investors considering this strategy should have experience using options and be familiar with the risks and the potential benefits before trading this strategy.

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

A portfolio hedge could be considered effective if the value of the hedged portfolio 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'd expect the hedge to be effective if it appreciates in value, offsetting some or all of the drop in equity prices.

As for cost, how much would a trader be willing to pay to hedge their entire portfolio for a certain time period? That may depend on what they think the market might do in the near future. 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.

Finding a single financial product to hedge an entire portfolio in all its uniqueness could be a challenge. But if the equity portfolio is well diversified, SPX put options could be an effective hedging product. Bear in mind that the SPX is market-value weighted and large-cap stocks dominate the index's performance. A different index might be a better match for a portfolio that's tilted toward smaller- or medium-sized companies.

Options on the SPX are considered 1256 contracts under tax law and offer the following benefits and special characteristics:

• Favorable tax treatment: Many broad-based index options qualify for 60% long-0term/40% short-term capital gains treatment—meaning 60% of your gains are taxed at the lower long-term capital gains rate, while just 40% are taxed as regular income. Other broad-based index options that qualify include those that overlay the Dow Jones Industrial Average^® ($DJI), Russell 2000 Index^® (RUT), and Nasdaq-100^® (NDX). However, one thing to be aware of is that 1256 contracts are subject to the mark-to-market rules. This rule requires all open contracts to be treated as they were sold at the end of the tax year, which could result in an unexpected taxable gain.
• Cash settlement: All index options are cash settled, meaning cash (not shares of stock) changes hands when contracts are assigned or exercised. The amount of cash is based on the difference between the strike price of the option and the settlement value of the index at expiration. Note: SPX options are subject to European-style settlement.*
• Leverage: SPX put options have a 100 multiplier, which provides the potential to offset a substantial decline in the portfolio and can involve a relatively small upfront cost, depending on the strike price and expiration of the option. Remember, even if the cost of index-based options may seem small compared to equity options, the goal is for the options hedge to expire worthless or lose value, with the risk of losing 100% of the cost of the options.

*European vs. American-style settlement: Options on the SPX and many other indexes settle European style and exercise or assignment can only take place at expiration; equity options and some index options are American style and can be exercised by the options owner any time prior to expiration.

Let's say a trader owns a $1,000,000 equity portfolio that's highly correlated with the SPX and they're concerned that 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 (more on this below).

Assume SPX is at 5,425 and the Cboe Volatility Index^® (VIX)—the average 30-day implied volatility based on a basket of short-term SPX options—is at roughly 12.50. The cost of one SPX 5,425 put option that expires in approximately three months is approximately $10,000 ($100 ask price x 100 multiplier, excluding transaction costs).

For this example, the trader is using the at-the-money (ATM) strike price to obtain temporary downside protection in the event of a sell-off. With the $20,000 they've allocated for hedging, the trader could potentially buy two SPX 5,425-strike put options for $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 you can see in the example above, not only did the hedged portfolio maintain most of its value during the various SPX sell-off scenarios, but it resulted in a net profit for the overall portfolio in the –5%, –10%, –15%, and –20% scenarios. However, in the first two scenarios where the S&P doesn't sell off (+5%, 0%), the hedged portfolio underperformed the unhedged portfolio due to the cost of the protection strategy.

• 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. If the trader does so, 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 higher, the hedge would've been more expensive, given that hedging costs rise in line with increased options premiums due to higher volatility expectations. Therefore, if the trader waited for the market to sell off, there's a high probability that the VIX could move above 12.5. This would be a sign that three-month ATM options are becoming more expensive, resulting in higher put prices and making the equivalent hedging strategy cost more than –2%. The converse is also true: If the VIX had been below 12.5, the equivalent hedge would likely cost less than 2%. 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 an ATM 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," and this can happen at any time throughout the life of the short option.) Because the trader purchased puts on an index that 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.

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 2% for the next three months. 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.

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