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Use of Options to Hedge Market Risk

Written by Param Shah
Mon May 09 2022
Use of Options to Hedge Market Risk - MarketXLS
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Use of Options to Hedge Market Risk - MarketXLS

A hedge is a risk-mitigation strategy for investors. A hedge is an instrument or method that increases in value when the value of your portfolio decreases. As a result, the hedging profit covers part or all of the portfolio’s losses. Several strategies are available to hedge different risks. Furthermore, there are a variety of ways to mitigate these hazards. Some portfolio hedging strategies protect against specific risks, while others protect against a wide range of threats. In this post, we’ll look at how to protect stock portfolios from market risks, including volatility and capital loss. On the other hand, investors can use portfolio hedging to protect against inflation, currency risk, interest rate risk, and duration risk.

There are many different ways of hedging stocks. We will look at five approaches using options. Options hedging is cheaper as it is a leveraged product. Deep in the money options which have an intrinsic value at the time of purchase are priced higher. Options that are a long way out of the money are priced pretty low, as there is little chance they will expire with any intrinsic value. The objective of an options hedging is to reduce the impact of a market decline on a portfolio. It can be accomplished in various ways, including using only one option or a mix of two or three.

Portfolio managers routinely utilize these five option hedging strategies listed below to reduce risk – 

1. Long Put Position

A long-put position is the simplest but the most expensive option to hedge portfolio downside due to market risk. Usually, an investor will purchase an option with a 5 or 10% strike price below the current market price for a time duration for which excessive market volatility is expected. These options will be cheaper but will not protect the portfolio against the first 5 or 10% that the index declines. The longer the put option duration, the higher premium the investor must pay.

2. Collar

A collar involves simultaneously buying a put option and selling a call option. By selling a call option, the premium received covers a part of the cost of the put option. Both options’ duration needs to be the same, while the strike price could differ according to market expectations. The trade-off is that the upside of the portfolio will be capped. If the index rises above the strike price of the call option, the call option will result in losses. Gains in the portfolio will offset these. This strategy is usually used by professional traders when they expect high volatility in the market for a short period. This cost-effective strategy provides a perfect hedge, but all upside gains will be washed in bull markets.

3. Put Spread

A Put spread strategy is used when the user is confident that the markets will be rangebound within a certain upper and lower limit. A put spread entails going long on a put option and shorting another put position with a different strike price. For example, a portfolio manager can buy a put with a strike price at 95% of the spot price and sell a put with an 85% strike. Again, the sale of the put will offset part of the cost of the bought put. In this example, the strategy would only hedge the portfolio while the market falls from 95% to 85% of the original strike. If the spot price falls below the lower strike, gains on the long put will be offset by losses on the shot put.

4. Fence

A fence is basically a combination of a collar strategy and a put spread strategy. In this strategy, an investor goes long on a put with a strike price below the current market level and sells both a put option with a lower strike price and a call option with a much higher strike price. The result is a low-cost structure that protects the portfolio from downside and at the same time allows for a limited upside.

5. Covered Call

In a covered call strategy, an investor sells out of the money call options against a long equity position. It doesn’t reduce downside risk, but the premium earned does offset potential losses. This strategy is more effective on individual stocks and hence more popular for an undiversified portfolio. Losses on the option position offset a certain amount of gains on the equity position if the stock price climbs over the strike price.

Selecting The Suitable Hedge Strategy For Your Portfolio –

There is no sure-shot way to choose the best available options when hedging stocks. However, the user can consider the pros and cons of the available strategies and make an informed choice. Several factors need to be considered while evaluating alternatives. The first decision will be to decide how much the portfolio needs to be hedged. If the portfolio is well-diversified, the entire portfolio is already hedged to an extent. However, maintaining a beta value of 1 at all times is not possible. In that case, there would be a requirement to hedge it.

On the other hand, if all of your wealth is in equities, at least 50% of hedging might be required. The user also needs to consider the portfolio assets and determine which market indices it most closely resembles. Calculation of the average beta of all stocks is also required. A larger hedge is required for a higher beta. Also worth considering is how much upside the user is prepared to forfeit. Selling of call options leads to a reduction in the cost of a hedge but at the same time limits gains.

After deciding upon the type of hedge that would make sense, one should also look at some indicative prices to determine how appropriate strategies will cost. For S&P options, a list of liquid options contracts can be pulled out any time using inbuilt MarketXLS functions. The user should have a particular view of the market (bullish, bearish, rangebound), evaluate different strategies in terms of cost and protection, and finally execute the strategy.

MarketXLS has in-built templates that aid to analyze all these strategies and choose which one suits best for your risk appetite and market view and execute the same.

You can go through the MarketXLS template (https://marketxls.com/marketxls-templates) &

MarketXLS Youtube Channel (https://www.youtube.com/channel/UC6pNfl-Re61QbCkjRb-6mYg/videos) to further understand all these strategies.

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