ETF options can be used to hedge your portfolio without reducing your overall equity exposure.
We are now getting into the heart of earnings season. Over the next two weeks (starting April 22), 309 stocks from the S&P 500 Index are expected to report earnings (FactSet). This includes most of the “magnificent seven” stocks that have been leading the market higher for the past several years. These names will likely take most of the media attention, but they are not the only names reporting over the next few weeks. Most of the largest stocks in the energy sector, including Exxon Mobil Corporation (XOM), Chevron Corporation (CVX), ConocoPhillips (COP), EOG Resources (EOG), and Valero Energy Corp (VLO) are all expected to report between April 30 and May 5.
Energy exploded higher in the first quarter, with the broad energy fund XLE up over 23% year-to-date (through 4/20). This outpaces the next closest broad SPDR sector fund (materials, XLB) by over 8%. Energy also rose to be the top ranked sector in our DALI rankings in March, a position it maintains by the widest signal margin (58 signals) of any adjacent sectors in our rankings.
The five energy stocks (XOM, CVX, COP, EOG, and VLO) combine to make up over 55% of the allocation within the State Street Energy Select Sector SPDR ETF (XLE) (as of 4/20). While each of these names have backed off so far in April, they are all still up at least 20% so far this year. The uncertainty surrounding energy markets, paired with earnings announcements for many of the largest companies in the space, make this an opportune time to consider portfolio hedging. ETF options can be used to hedge your portfolio without reducing your overall equity exposure since they can act as a proxy to hedge multiple positions. We’ll focus our examination today on the five names reporting earnings listed above. However, the same strategy can be used to hedge almost any portfolio. All you need to do is find an ETF that is positively correlated with the stocks you want to hedge, then determine the number of options contracts to purchase using the steps outlined below. The advantage of this strategy is that instead of buying protective puts on each stock individually, you can hedge an entire portfolio (or sleeve) using put options on one ETF.
The hedging calculation above assumes a one-to-one relationship in the price movement between the portfolio and the hedging ETF. If you want to increase the precision of your hedge, you can calculate a beta for your portfolio vs. the ETF. To do this, you simply calculate an ETF beta for each stock by multiplying the correlation of the stock and the ETF by the stock's standard deviation divided by the ETF's standard deviation (the standard deviation for each stock can be obtained by putting the stock into a portfolio and enabling the "Standard Deviation" header under the "Settings" tab). You would then take a weighted average of the individual betas you calculated to get a beta for the entire portfolio. This process is outlined below.
Once you have the portfolio beta, you multiply it by the number you calculated in Step 4 above to get an adjusted number of contracts to purchase to hedge the portfolio. In this case, our result would be 97 contracts (90.8*1.06). In this case, incorporating a beta into our hedge made it more expensive. However, the point is not whether our hedge has become cheaper or more expensive, but that we have made it more precise. Paying about 4% of your portfolio in option premiums is a notable outlay, although it may be prudent given the potential for a volatile earnings season. Just as with auto insurance, you can lower the overall cost by increasing your deductible and/or lowering your coverage limits, thereby lowering your overall level of protection. So, instead of hedging the entire value of the portfolio, you can choose to hedge whatever portion fits the situation or accept more downside risk by lowering the strike (and the price) of the put option.
