When the market starts to tank, there are a couple of things you can do. If you have an iron stomach, you can sit through the turmoil and do nothing and take the chance that prices will recover before your losses become too severe. But you can also be proactive and protect yourself against further declines in stock prices by employing various hedging strategies using options.
Let’s take a look at the two most common ways to hedge long stock positions with options.
- Buying put options on the S&P 500 is a common hedging method
- Buying call options on the VIX or UVXY is also a way to hedge
- Always keep your hedges small to avoid a situation where the loss from hedging is larger than your original investment loss
- Hedging is only intended to mitigate losses, not eliminate them
- Keep your feels low and use Ally Invest for all options purchases because they are the cheapest options broker
Buying S&P 500 Put Options
When most people think of hedging strategies using options, this is probably what comes to mind. It’s by far one of the most simple and effective methods of reducing losses in a long stock portfolio.
Essentially, if you buy a S&P 500 put option, (ticker symbol SPX) you are given the right, but not the obligation, to short the S&P 500 at the strike price of the put option you purchased.
As the price of SPX drops, your long put option will theoretically increase in value. Increases in volatility will also positively affect the value of long put options (more on this later). See the graph below of the profit and loss of a long put.
Put buyers need to be aware of a couple things. First, puts often trade richer to calls due to implied volatility. This is because other market participants realize that stocks usually tend to crash down, not up.
As such, investors are willing to pay a premium for out of the money options that will pay off when the underlying asset declines in price.
Simply put, there are more possible situations where the S&P 500 could crash down 25% in one day then there are where it could crash up 25% in one day.
Buying VIX or UVXY Volatility Calls
When markets are chaotic, some investors prefer to buy volatility itself as opposed to buying put options on stock indices.
Although there are a few different ways to purchase volatility, the most common way is to buy call options on the CBOE VIX Index.
The price of the CBOE VIX Index is derived from the prices of call and put options on the S&P 500 Index. As prices of calls and puts increase, because investors want to hedge their stock portfolios, volatility and uncertainty also increases.
If you buy VIX calls, you will profit when the VIX increases, and when the VIX increases, it tends to do so quite dramatically.
This 5yr chart of the VIX displays how price levels can go from 10 to 25 in only a few days. When the VIX is at 10, and you buy 20 strike call options, and stocks crash and volatility subsequently rises, the long VIX calls will profit nicely. Of course, this is assuming volatility volatility rises and stocks crash, it doesn’t always happen like that.
One of the risks of buying VIX calls is that nothing will happen in the markets and the calls will ultimately expire worthless. However, since the calls were only a hedge, and not a speculative position, the ultimate goal is actually for the calls to expire worthless, because this means your core position of long stocks did not lose value. If the calls appreciate in value, this likely means that your long stock position decreased in value, which is not what you want to happen.
As noted in one of our unusual options reports, institutional investors with hundreds of millions of dollars buy VIX calls to protect their long stock positions.
Buying volatility call options is a proven and effective method for neutralizing portfolio beta and hedging against losses.
Without a doubt, one of the core principles of hedging is to keep your hedge size small. This means that the loss of your hedge should never, under nay circumstances, outweigh the loss of your original position that you hedged.
As such, this ultimately means that, in a perfect world, your options hedges will expire worthless and your core long stock position will be profitable. Hedging is merely a way to minimize losses, if they occur. It is not a way to profit from asset price declines.