Using Options Strategies to Mitigate Volatility
The current bull market in U.S. stocks has now entered its seventh year and continues chugging along. In such a market environment, which has lacked a meaningful correction in either magnitude or duration, it’s easy to become complacent. However, the pull back last October and the choppiness markets experienced in December and January should serve as a reminder that the long period of low volatility has likely ended.
This low volatility over the past several years can largely be explained by the Fed’s policy of Quantitative Easing (QE). Now, with QE in the rear-view mirror and a rate hike expected later this year, it is likely volatility may increase. In fact, there have already been signs volatility is increasing, because the average level of volatility for 2015, as measured by the VIX average YTD, is higher than it was from 2012 through 2014 (17.4 vs. 15.4). Plus, there are several other factors that may contribute to an increase in volatility in 2015, including: The effects of divergent Central Bank policy between the U.S. and the rest of the world, concerns over slowing GDP growth, concerns over slowing earnings growth for S&P 500 companies, which has recently seen concerns become more heightened due to a strong U.S. dollar, stretched valuations, and another significant change in the price of oil.
Given that volatility tends to revert to the mean, and therefore may be likely to rise, it makes sense to think about ways to protect your current equity portfolio. We believe one of the best ways to do this, without exiting the market, is with options. Using options to protect an equity portfolio is commonly referred to as a hedged-equity strategy. There are a variety of options strategies that can be used to hedge an equity portfolio, depending on how much risk one is trying to avoid. Regardless of strategy, the goal is to create a portfolio with a more favorable risk-reward profile, relative to a portfolio solely invested in equities. It is important to keep in mind that since options have expiration constraints, hedging your portfolio with options requires a more active management style than just buy-and-hold.
The two basic building blocks of any hedged equity strategy are contracts known as puts and calls. A put option is the contractual right to require the sale of a security at a specified price. A call option gives the owner of the call the right to buy a security at a specified price. In each of these cases, the specified price is known as the “strike price.”
One popular hedged-equity strategy used to mitigate downside risk is known as a collar, which involves selling a call and buying a put simultaneously. By owning puts with a strike price below the current market price, the total downside of the position is substantially mitigated. This downside protection can be expensive, so one can offset this cost by selling calls. Selling a call means potentially giving up some of the upside should the price of the underlying equity rise above the strike price of the call, therefore, it’s important to make sure the calls are not sold below your target price in order to avoid capping your upside too tightly. This specific risk-return profile is why the strategy is referred to as a collar: Both upside and downside are capped, creating a narrower band of returns. It is also important to note that when both options contracts are executed, at the same time, it’s possible to construct the transaction as a cash neutral trade, which means there is no initial cash outlay.
In addition to using options to hedge an existing position, you can use options to create a “synthetic long” position. In other words, you can create directional exposure in an equity security without actually owning the stock, while also potentially lowering the risk of loss in downside scenarios. The risk reversal, another popular strategy, is an example of this. Interestingly, the risk reversal is basically the opposite of a collar: Instead of selling a call and buying a put, one can simultaneously sell a put and buy a call. In this case, owning the calls allows the owner to partially participate in an upside move should there be one, however, by selling the put, the investor would have some cushion to the downside before losses were incurred. This strategy can create an attractive risk return profile as it creates a directional view, while also limiting the risk of the options expiring worthless in a flat market.
The benefit of these strategies is twofold. Not only can they be used to manage the risk of a price decline, but when a pullback occurs, put options also benefit from volatility. This is because as volatility increases, the value of the option premium increases, providing mark-to-market gains, while the decline in the underlying equity security increases its intrinsic value. These two factors can provide ample protection in a market drawdown, which may dramatically lower the volatility of a portfolio’s returns.
Option strategies can be constructed for any unique view of the market and may bring different benefits and risks. It is vital to do your research when figuring out what best serves your purposes. Many have come to the conclusion that since implied volatility is at historical lows, buying puts are essentially cheap. This can be deceiving, as implied volatility tends to trade at a premium to historical or realized volatility on the underlying asset, which highlights the importance of dynamically adjusting one’s hedging strategy to any given environment.
Overall, hedged equity may be an important strategy for any investor seeking to participate in equity markets while attempting to reduce the short-term volatility that can wreak havoc on a portfolio.
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The opinions expressed are as of the date written and may change as subsequent conditions vary. This paper is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader.
