A Strategy to Hedge Volatility

04/05/2010 10:28 am EST

Focus: MARKETS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, chairman of Schaeffer’s Investment Research and editor of The Option Advisor, says it’s cheaper to hedge stocks and ETFs in your portfolio than the market.

The steady decline in the Chicago Board Options Exchange’s (CBOE) Volatility Index (VIX) over the course of the market’s rally from the March 2009 bottom has been noted time and again in the financial media, and, indeed, over the past 12 months the VIX has declined by an eye-opening 58%.

But this pales in comparison to the decline in the implied volatility (IV) of many options on industry-specific exchange traded funds (ETFs) and individual equities. [Here are] some examples of IV declines from the March 2009 peaks, based on the Schaeffer’s Volatility Index , our exclusive measure of equity option pricing.

Decline from March 2009 IV Peak

Financial Select Sector SPDR (NYSEArca: XLF) -79%
iShares Dow Jones US Real Estate (NYSEArca: IYR) -76%
Ford Motor (NYSE: F) -73%
Meritage Homes (NYSE: MTH) -72%
Starwood Hotels (NYSE: HOT) -71%
General Electric (NYSE: GE) -69%

Why has the pricing of equity options taken a bigger hit over this period than that for index options as represented by the VIX?

In my opinion, it is “the fear factor” that continues to dominate the pricing of index options—the concern about a sudden market crash. Since index options in general, and Standard & Poor’s 500 Index (SPX) options in particular, are predominant among those used to hedge portfolios against such dire eventualities, these options (and hence the VIX, which is a measure of their volatility) are always “juiced” due to excess demand for crash protection.

While the VIX is in the 18 area, recent historical volatility of the S&P is well below 10%. In fact, index options have been expensive on this basis for many years, which is supported by the success over the years of a number of real-world index premium-selling strategies.

According to the CBOE website, in 2006 Callan Associates published a study on the CBOE S&P 500 BuyWrite Index (BXM) that concluded that BXM generated superior risk-adjusted returns over the last 18 years, generating a return comparable to that of the S&P 500 with approximately two-thirds of the risk.

But on the flip side, equity options are quite cheap—relative to index options and relative to their levels of just one year ago. And this presents an excellent opportunity for option premium buyers.

The traditional “strategy spectrum” recommendations under such conditions would be to buy cheap call options as “stock substitutes” and pocket the difference between the capital required to own the shares and that required to buy the calls—or to buy cheap put options to protect your stock portfolio.

My suggestion would be to combine the best of both of these worlds by buying call options paired with lower-delta put options on the same stock to benefit from cheap “stock substitution” and the cheapest put protection.

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