2 Proven Ways to Hedge with Options

09/08/2011 8:30 am EST

Focus: OPTIONS

Lawrence McMillan

Founder and President, McMillan Analysis Corporation

Buying index options or VIX options are cost-effective methods for insuring your portfolio against downside risk, says Larry McMillan, who shares tips for choosing the right option to buy.

Professional traders always have a hedge on their trades to make sure that they limit their risk. Retail traders should be doing the same thing, but how do you actually do that? 

Our guest today is Larry McMillan to talk to us about that. So Larry, how do I do an overall portfolio protection plan?

Well, the way I would suggest is what the pros call “macro protection.” In other words, you buy an index option to protect your whole portfolio rather than going in and buying individual puts on every stock that you own.

That’s very time consuming and tedious really, so if your portfolio doesn’t exactly behave like the S&P 500 or the QQQ’s—it probably behaves more like one or the other of those two, but that’s the index I would select.

Traditionally, let’s say, you would buy SPX puts; about 10% out of the money, and you would just hold them maybe three months out. You’re buying three months out, and you just hold them and then roll them over again. 

We did a study for Nuveen a couple years ago, and if you did that, you bought 10% out of the money, three-month SPX puts. Over time, it really only costs you about 2% of your net asset value every year, so it’s a fairly small cost of insurance, and of course, if something really bad happens—like in 2008—then SPX falls and while your portfolio may not exactly perform like SPX, you’re still going to make a lot of money on those puts and hedge your risk. 

In more modern thought nowadays, traders are leaning towards using VIX calls as protection because they’re even more dynamic.

Typically, when the market goes down, the Volatility Index (VIX) goes up, and it goes up fast. In 2008, it went all the way to…like 90-something, but you want to be long calls on that because if the disaster happens, VIX will accelerate so quickly to the upside that you’ll actually make money…quite a bit of money. 

In fact, here’s an interesting statistic: VIX calls started trading in 2006, and if you had bought the one-month call, seven points out of the money or seven-and-a-half points out of the money, whatever, every month and just kept rolling it over, to this date you’d be ahead $3000 on that trade.

There’s nothing else you can say that’s true about, but VIX is so volatile when the market falls, it explodes so fast that in 2008, in the flash crash in May 2010, and then a couple of other times, you made enough money on just those few times to pay for the cost of your protection all the way along.

So the more modern theory is to buy VIX calls about seven points out of the money and just one month out in time and just keep rolling them over.

They cost less than a dollar; $0.50 maybe, most months. This month’s a little more expensive because VIX has now gotten a little excited because the market’s been going down, so you might pay more.

I think we just paid $0.90 the other day, but still, it’s not a huge expense, and you don’t have to hedge your entire portfolio.

You really only hedge about 20% of the net asset value of your portfolio because when things happen, VIX is so volatile that you only need a 20% hedge and it will make up the difference. So that’s the modern way.

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