Hedging with Options

When trading options or any other instruments, it always pays to be cautious, and Steve Smith of Minyanville.com shares some tips to protect your positions, portfolio, and your trading account.

When writing as an options educator and something of a proselytizer I try to keep in mind the Hippocratic Oath of doing no harm. So to avoid turning our little bit of knowledge into the roots of financial self-destruction, we'll go through some tips that can help you avoid blowing yourself up. And then we'll look at some ways options can be used to protect your positions and portfolio when outside forces turn against you.

• Understand what you are trading. Do not use products you are not completely comfortable with. Review the contract specifications, such as size, assignment style, dividend dates, and settlement process. In recent years, there has been a tremendous proliferation of products; for my part, I avoid trading those related to the VIX, or that are leveraged or inversed.

• Understand leverage. Leverage can cut both ways. The first and most important rule is to never base the number of options contracts you are buying or selling on the notional value as you would with stocks. Do it on a share or delta basis. For example, if you are taking an options position based upon the expected movement of $5,000 worth of stock (say, 100 shares of a $50 stock), do not buy or sell $5,000 worth of options—rather, use the number of options contracts that will give you exposure to those 100 shares.

• Limit risk of positions. Never sell an option naked or uncovered, which can carry unlimited risk. For example, to take a bearish position on Apple (AAPL), it would be extremely risky to do something like sell the October $630 calls for $11 with the stock trading at $625. Let's say investors got excited about the new iPhone, and sent Apple higher. After it hits $641 ($630 + $11), the losses start adding up quickly. If the option expired with the stock at $650, the option seller would incur a $900 loss ($650 - $641) per contract. And at $660, it would be a $1,900 loss. If you want to sell or collect premium, use a credit spread to limit the downside risk. Buying an option will limit your risk to its cost.

Hedging and Protection
In my options trading, I try to have individual positions that have their own internal hedges by using spreads. These usually take the form of basic vertical spreads or calendar spreads. The essential function of a spread is that by both buying and selling options on the same underlying security, you will be reducing the impact of changes in implied volatility and time. The strategy you choose will determine which variable you want to de-emphasize.

I also frequently use options on the Spyder Trust (SPY) to provide the overall portfolio with broader protection. Typically, individual positions tend to be bullish, while the portfolio protection chunk usually consists of the purchase of puts or put spreads. Let's take a look at how this concept can be applied to a less active and basically bullish-oriented portfolio.

NEXT PAGE: A Combo Approach to Hedging

Buying put options does offer the most complete and probably efficient way to hedge a position, but it comes at a cost. That cost, as with all insurance policies, will be a function of the amount of protection and its duration.

The main items to consider when choosing put protection, whether for an individual stock or a broad equity portfolio, are as follows:

• What magnitude of a decline is expected?
  
• At what level of the decline do you want the position to be fully hedged or protected?
  
• For what length of time do you want the protection in place?
  

Answering these questions will help you determine the appropriate number of puts to buy at a given strike with a certain expiration date. By using the basic application of delta, in which an at-the-money option is expected to move $0.50 for every $1 unit price move in the underlying security, one can begin to asses how much and at what levels cost protection can be purchased.

A great tool can be found at Schaeffers.com. Its portfolio calculator lets you play around with various levels of put protection for a portfolio of stocks representative of the S&P 100 Index (OEX).

Combination Approach
If you're really looking for a true, longer-term hedge—that is, you don't expect to make many changes or adjustments to your portfolio for six months or more—using a combination of strategies might make sense.

For example, I suggest the following three-step approach, which uses SPY options to create portfolio protection for a $150,000 portfolio:

1. Buy a put spread of closer to-the-money strikes that have about six months remaining until expiration. With the SPY trading around $140, one can buy the January $135 puts and sell the January $125 puts. Such a spread could be bought for around $2.50 net debit. For a $150,000 portfolio, purchasing about 100 of these might provide reasonable protection. But because we're protecting it in two other ways (read on), buying 25 spreads should suffice.

2. The next step is to sell a call spread for a credit, such as selling the January $145 calls and buying the January $150 calls. This call spread can garner about a $1.50 net credit. Remember, as a spread, this won't limit your upside. You could probably sell up to about 50 or 60 of these spreads. Just be aware that there's a "dead zone." If SPY is between 145 and 150, then you'll lose $3.50 on this position. But I assume you'd be making money if stocks rallied another 10% from current levels. You can use higher strikes or sell fewer spreads to align with your risk profile.

3. Finally, use the proceeds of the call spreads to buy some out-of-the-money (or OTM) puts outright to provide deeper downside protection. For example, the $7,000 proceeds from the call spread would finance the purchase of about 20 of the January $117 puts. These OTM puts give you outright disaster protection should the market head back towards last October's lows near the $110 level.

The total outlay would be about $11,000—or about 7% of the $150,000 portfolio—which isn't too steep for over six months of portfolio insurance.

This is just a loose construct—you can play around with the numbers—but I think the best hedges will ultimately involve more than simply picking one strike.

By Steve Smith, Contributor, Minyanville