Simple Hedging Strategies for Anyone

01/23/2013 9:15 am EST


James Fink

Editor, Jim Fink's Options for Income and Stocks to Watch

In today's market, investors need to be prepared for unexpected reversals, says James Fink, who shares some basic ways to protect yourself.

Why hedge? We're here with Jim Fink, who is going to tell us not only why to hedge, but strategies for hedging.

Hi, Gregg. Nice to see you. I think the reason to hedge is because the market is traditionally very overvalued at the current time. You know, you see a lot of people here at these MoneyShows talking about market timing and trying to pick the absolute tops and bottoms. I don't play that game. I don't think anyone can play that game.

What I do believe you can do is look at history, look at the general valuation levels of the market. If they're very overvalued on a historical basis, I think you should take a look at hedging as something important to do without a market timing component.

Then when you're not using a market timing component, what are you using?

Well, I think the two best ways to hedge right now are to use S&P 500 put options and VIX call options. The VIX is the implied volatility index on the S&P 500 options. So if the stock market goes down, the VIX traditionally goes up, so you would want to buy VIX call options.

So you're going long volatility?

Long volatility.

To hedge your portfolio?

Right. Stocks go down, volatility goes up generally. The other thing you can do is you can buy put options on the S&P 500 directly. So obviously when stocks go down, put options go up in value.

And are there any other strategies? I know that sometimes in bear markets, or at least stagnant markets, you can use spreads, for example, to derive some income off of stocks that might not be moving. Are you anticipating a market where we're going to see some increased dynamics, where maybe the VIX does increase or that the S&P will return to the mean?

Right. I mean you can use VIX calls and SPX puts to guard against an increase in volatility. Once volatility has increased in value, then you would start looking at selling options-selling covered calls to hedge a long stock portfolio, because when you're selling calls that brings in extra income for our portfolio.

You could also, if you don't already own stock, you can just sell puts as a way to enter a stock position at a lower price than what is currently in the marketplace. Both selling covered calls and selling puts are best done when volatility is high, so that the premiums you receive from selling them are generous.

Right now, that is not the case. Right now, the VIX is trading at near a five-year low. So I would not recommend selling covered calls and selling puts as your main strategy right now. Right now, the best way is to buy volatility.

And with volatility so low, if you're using this as a hedge, how far out would somebody buy a contract? Would they go out a month, three months? Would you buy a LEAP on something like this?

I think that a lot of the VIX calls are based on futures. The way VIX futures works is longer-term VIX futures are much more muted in their changes, because the thinking is that the VIX is a reverting index. It doesn't go all the way up or all the way down. It has a very defined oscillating range between perhaps 10% annual volatility on the low end and 2008 it went up to 80% on the high end.

So when you're going out long term, the thinking is that it's not going to be at one of those extremes. It's going to revert to the mean, so you don't get much bang for your buck when you go out long term. So with VIX calls, I really think you should stay on the shorter-term side of things.

Related Reading:

How to Trade the VIX

What to Do in Low-Volatility Markets

A Retiree-Friendly Income Strategy

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