How to Hedge with Options

02/28/2013 10:04 am EST

Focus: OPTIONS

Michael Khouw

Partner, The Options Edge

Options expert Michael Khouw explains how any trader or investor can hedge their portfolio with options.

One of the questions many people have today is how you hedge a portfolio of stocks or other investments with options.  My guest today is Michael Khouw to talk about that, so Michael, there are a lot of different ways to hedge a portfolio with options, one being selling puts if you're owning something.  What are some general strategies you can use options to hedge for? 

Well, I think one probably of the best hedges for a portfolio in general that people don't think about is selling options and you would say, well, isn't an option insurance?  Isn't that how I would normally hedge?  I think the important thing for people to recognize is that what you're looking for ultimately is superior risk-adjusted returns, right?  That's the whole objective of hedging and if we know that insurance is typically overpriced, we'd rather be the insurance company selling it as a part of our investment strategy than buying it hoping that somehow it pays off, which if it does, means that the rest of our portfolio has probably been hit pretty hard.

If you override stocks that you own consistently, you end up lowering the cost basis of that stock over time.  You can cap some of the upside gains, there's no way to get something for nothing, but in general what ends up happening is you get a portfolio that has lower volatility over time and even if it delivers approximately the same returns, which we've seen from academic studies that that's basically what you get, you have lower volatility so you've actually affected a hedge of some kind.  That's really the whole purpose. 

We don't want to put our money in and watch it lose 30% of its value.  If we can come up with a strategy that delivers similar returns but with lower volatility over time, I think we've done a hedge so I think probably the first thing that anybody who's thinking about trading options to hedge should do is probably think about overriding stocks that they own.

Another question that comes up a lot is how far out should I put my expirations, should I buy LEAPS or regulars or even weeklies?  What's your advice there? 

Okay, I think that's a phenomenal question and of course there are so many options, expirations, and strikes now it becomes a whole lot harder to figure that out, right?  I don't recommend selling longer-dated options as part of an overriding strategy or a covered put writing strategy and the reason is those options just simply don't decay very rapidly.  That's one problem. 

The other problem is that trends in stock prices tend to occur over longer periods of time so if we take a look at how stock prices behave over say a decade, people would say well, it's very obvious that you wanted to own them.  In the middle is when it really moved around a whole lot so if you sell a long-dated option, the market may have moved by a huge amount in the intervening period with a lot of intervening noise.  You don't want to be short options and have them end up very deep in the money so I think usually what I look to if I'm looking for overrides, 90 days and in is usually the guideline. 

What about weeklies?  Do I want to sell weeklies?  Well, actually there I probably would steer away too, the reason being that it's true that they decay very rapidly and the math sort of works for you but there's another component.  You tend to be selling very dollar-cheap options and that's a very tricky business because if you're not really aware of any intervening catalyst, what if they're going to be announcing earnings, what if there's an important economic announcement?  What if they're having an analyst day?  There are all kinds of things that can drive stock prices vary sharply in the near term but don't tend to have as much of an impact over a somewhat longer period of time.  If I was going to initiate a position, longer than 30 days, less than 90, is probably where I'd start. 

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