With volatility near its lowest point of the year, we examine the process for hedging a portfolio using ETF options.
With CPI data coming in line with expectations this Wednesday morning, the CBOE SPX Volatility Index (VIX) fell to 14.5, its lowest level since January. However, there remains an elevated level of uncertainty in the market on top of entering what has historically been a volatile period for the market. Despite a relatively cool CPI reading, the fed futures market is still pricing in a better than 65% chance that the Fed will raise interest rates by at least 25 bps by the end of the year, there still has been no clear resolution to the conflict with Iran, and mid-term elections are on the horizon. Meanwhile, we’re only about two weeks away from the beginning of September, which has historically been the worst month of the year for US equities.
With heightened uncertainty and the low volatility (as measured by the VIX) making it relatively cheap to do, this is an opportune time to consider hedging your exposure. Our example later will focus on fully hedging a portfolio with at-the-money puts through the rest of the year, but this can be adjusted depending on client needs and cost constraints. For example, instead of hedging against any decline, clients may only want to hedge against a decline of more than 5% or only half the value of their respective portfolio. In any case, there is flexibility for any situation.
Given the level of concentration in the market – five stocks ((NVDA), (AAPL), (MSFT), currently account for almost 30% of the S&P 500 (SPX) – we’ll look at options on the Invesco QQQ Trust (QQQ), which is heavily concentrated in the largest stocks in the market. But any ETF with liquid options can be used in the same way. If you wanted to create a broader hedge, you could use options on SPY or if you wanted to only hedge semiconductor exposure you could use options on the iShares Semiconductor ETF (SOXX).
Like single stock options, ETF options are usually physically settled, i.e., if you exercise a put option on an ETF or hold it to expiration, you will be expected to deliver the underlying ETF at the strike price; therefore, it may benefit you to close any ETF option positions you have before expiry.
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 stocks into a portfolio and enabling the "Standard Deviation" header.) 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 6 contracts (6.8 * 0.91). In this case, incorporating a beta into our hedge made it less expensive. However, the point is not whether our hedge became cheaper or more expensive, but that we have made it more precise.
Paying more than 3% of your portfolio in option premiums is a notable outlay, although it may be prudent given the potential for volatility. 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 only half or whatever portion is suitable for the situation or instead of using at-the-money puts you could allow for a bit more potential downside and use out-of-the-money options.
