Can traders stay hedged all the time?
Chris McKhann | email@example.com
Short-term put buying is often the best way to hedge a long equity portfolio amid the vagaries of earnings and other anticipated catalysts. In this volatile environment, however, some people are looking for ways to shield their investments from unforeseen consequences as well.
In these cases, longer-term puts can make sense, up to a point. Many traders buy six-month puts and then sell them with maybe six weeks before they expire to avoid the most time decay eating into premiums. Using puts in indexes or exchange-traded funds, such as the SPDR S&P 500 Fund (SPY), can be a good alternative to contracts in individual equities for protection against broad market drops.
In theory, having the direct protection that puts afford allows investors to sleep well at night and not worry about the inevitable, if infrequent, downside shock. But life is not so easy.
Hedging is clearly a drag on performance. Puts, especially those in the indexes and their ETFs, are notoriously expensive. Many studies have been done about the so-called implied volatility premium, which results from put sellers requiring a premium over actual volatility to compensate for the risk they take.
In this regard, the CBOE has done us a great service in the various indexes it has created and maintained. The most useful in this case is the CBOE S&P 500 PutWrite Index (PUT), which consists of selling one month at-the-money puts.
The PUT index has a return of 1,153 percent from mid-1986 to the end of 2011 compared to a return of 807 percent for the S&P 500, according to the CBOE. And the PUT did it with 30 percent lower volatility in a period that included the crash of 1987 and the 2008 crisis.
So owning puts all the time against your long stock may not be such a good idea, especially if they are index puts that are only one month out. One way to mitigate some of that cost is to use collars--selling calls to offset the cost of the puts. And there is an index for that too.
The CBOE S&P 500 95-110 Collar Index (CLL) holds the S&P 500 stocks, buys three-month puts at 95 percent (of the SPX value), and sells one-month calls at 110 percent. Unfortunately, its long-term performance is quite bad.
From the end of June 1988 through the end of 2011, the CLL had an annualized return of just 6.1 percent, compared to 9.1 for the SPX and 10.8 for the PUT. The standard deviation (a measure of risk and volatility) was 10.8 percent for the CLL, less than the SPX's 15 percent but above the PUT's 10.2 percent. So collars may not be the answer either.
Constant hedging clearly has its costs, and they simply appear to be too high to sustain. Academic studies have been done about the costs of perennial protection--especially as "tail risk" hedging has gained in popularity--and most of them conclude that such hedges aren't worthwhile, especially if we don't get another 2008-type crash in the near future.
Put buying or using collars can be a great way to hedge, but they are best used tactically instead of constantly. Next week we will look at other solutions to the hedging conundrum.
(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of July 18.)