If you are sitting on stocks for retirement that you have accumulated outside of your 401k or IRA, then you may feel particularly vulnerable to a stock market correction. Depending on your adversity to risk, there are ways to lessen the impact of a correction. Options trading provide numerous strategies that can be used to lessen the effects of an adverse move in the market. The main question is your risk tolerance and would you be willing to put more money to work at lower levels?
Everyone has a different level of tolerance for risk. The diffference can consist of psychological composure, stage in the life cycle and numerous factors that are very complicated. Those with risk capital should likely be willing to purchase more stocks, or an index of stocks like the S&P 500, when markets decline rapidly. Others, who are looking to soften the blow on the way down, may have completely different strategies that will meet there needs.
There are numerous options trading strategies that would be good choices for individuals interested in hedging some of their portfolio risk; here are two of them.
1) Purchase of Outright Puts: in a low implied volatility environment this may be an effective strategy for you if you have excellent timing regarding a correction. Out-of-the money options frequently expire worthless and unless your timing is good you end up purchasing an option whose implied volatility is in excess of the historical volatility of the underlying. Due to the recent volatility in the stock market, options are priced (implied volatility) significantly below the historical volatility. An example of this pricing structure is shown below. The Options Guide PDF may clarify a few of these points.
2) Another technique that is particularly worthwhile for those that are hedging stock market exposure involves using the implied volatility skew to provide a pricing advantage. The strategy involves selling a call spread and buying a put spread equidistant from the current trading price. The structure of the curve provides a pricing advantage that you can see below. While the strategy does not provide a significant hedge in the event of a market collapse, it does provide the opportunity for hedging against a portion of the market decline. The Table below includes the basic strategy which can be modified to meet the individual’s needs.
The Table below provides options prices from Monday afternoon and the structure of the strategies discussed above. The out-of-the money puts described in the strategy of outright long puts in section one can be analyzed using the prices and implied volatilities in the Table. It is clear that the options market does not believe that future volatility will be anything like what we’ve had in the last 20-days. The Table shows that while the Historical Volatility (shown in the bottom right) is 24%, the out-of- the money put shown in the 2070 put has an implied volatility of only 13.73%. The differential between implied and historical volatility is staggering. Normally the implied volatility of the out-of-the money puts is higher than the historical volatility. But the last several weeks has produced an extraordinary trading environment. If you’re nervous about an outright correction and confident in your timing, the outright purchase of puts may be the correct strategy for you.
My favorite hedging strategy for a portfolio is described in the second strategy and is also shown in the Table below. It provides a no lose position if you’re already long stocks, because if the market rallies you still make money on your long stock. If the market goes down, at least you’ll make some money on your hedge. It is a pure hedge of any amount that you’d like to trade and the market, due to the skew, allows you to receive a credit to initiate it. It is available in the E-mini S&P Futures as shown or in SPY (S&P 500 ETF Trust) in a slightly modified version. The Table below outlines the hedge which sells the 2160 calls and buys the 2190 calls thereby establishing a short position with limited risk. At the same time, we will purchase the 2100/2070 put spread which is also a limited risk short position.
The Table shows that while the put and call spreads are equidistant from the current trading price of the E-mini S&P you can actually get short the market for a credit of 3.38 on a 30 point spread. In contrast, if you were to sell the 2190 calls and buy the 1970 puts, also equidistant from the current trading price, you would have to pay more than 9 points. The reason for this is the implied volatility skew. If any of this is unclear to you, consider a complementary individual webinar to clarify some of the mysteries of options trading.
Options trading involves significant risk and is not suitable for every investor. The information is obtained from sources believed to be reliable, but is in no way guaranteed. Past results are not indicative of future results.