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Hedging

Hedging. 1. Objectives. a. What is a hedge? b. When to use a hedge c. Instruments and strategies d. Examples. 2. Definition.

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Hedging

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  1. Hedging

  2. 1. Objectives • a. What is a hedge? • b. When to use a hedge • c. Instruments and strategies • d. Examples

  3. 2. Definition • A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization. • Protection against losses, lock in profits , Price risk transfer , Lower portfolio volatility

  4. A Hedge is an Insurance Policy • Like all insurance there are costs. A more effective hedge is often more expensive. Finding your ”sweet spot” between cost and protection

  5. 3. Must determine what you’re hedging against • a. General market decline • b. Market sector decline • c. Company specific (earnings, overvaluation etc..) • d. Static Market

  6. 4. Instruments • a. Best Hedge is Cash. Not always practical • b. Options • c. Inverse ETF • d. Futures

  7. 5. Option Strategies for General market decline • a. Index or Sector Puts • b. Index or Sector Bear Put Spread (Warning – increasing IV of short put can limit gains) • c. Puts or bear put spreads on Individual Stocks in Portfolio • d. Collar • e. Option Replacement • f. Bear Call Credit Spreads • g. VIX calls. • h. SPY/VIX paired trade • i. Binary Strategies: OOM VIX calls, ‘Fly, OOM Bear put spread

  8. 6. Inverse ETF strategies for General Market Decline • a. Major Index : ex SDS • 1. buy-stop • 2. Beware effects of negative compounding • b Weak on underperforming sector : ex SRS • 1. buy-stop • 2. Beware effects of negative compounding • c. Volatility ETF: ex VXX • 1. Beware the effects of VIX futures contango. This will limit your effectiveness. More effective when Futures term structure is flat or backwardation

  9. 7. Option Strategies for hedging individual stocks • a. Put Purchase • b. Put spread--- straight, ratio • c. Collar/Conversion

  10. 8. Strategies for hedging a Static market • a. Covered call writing • b. Credit spreads • c. Covered Strangle or Straddle

  11. 9. Example of a collar • Bought 100 shares LMT march 2009 at $60/ share or $6000 • Now LMT is $126 share value of $12600( 110% gain) and investor wants to protect his gains till Jan 2014 • Buy Jan115s put @ 2.55 for debt of $255 • Write Jan 130s call @ 2.75 for credit of $275 • Net credit $20 • So if LMT is less than $115/share on 1/1/14 investor can sell put • or exercise put. If investor exercises put his position will never be worth less than $115.20/share or a 92% gain. If LMT closes over $130/share investor’s stock will be called away for a credit of $130.20 or a 117% gain.

  12. 10a. Example of using index options to hedge a hypothetical portfolio. ( Beta hedge : Beta , Delta hedge) • Assume a 3 stock portfolio, $10,000 or each purchased Oct 2011. ( note PL , ASPS have illiquid options) • Stock Purchase Price Oct 2011 Price Aug 2013 % gain • WLP 62 86 39% • PL 15 43 186% • ASPS 35 127 262% • Shares Value Aug 2013 Beta • WLP 161 $13,850 .86 • PL 666 $28,640 3.02 • ASPS 285 $36,200 .55 • Portfolio beta = 1.5 $78,690

  13. 10b. Example of using index options to hedge a hypothetical portfolio. ( Beta hedge : Beta , Delta hedge) • So to hedge with SPY options need to adjust number of contracts for the portfolio beta • (78,690)(1.5) = $118,035 • If SPY is 166.62 then need 118,035/166.62 contracts or about 7 contracts • However your put option has a delta less than one so need to “delta hedge “as well • Sept SPY 166s put. 2.35. Delta .44 • So to establish a delta neutral position where you have locked in the value of the portfolio • Buy 7/.44 or 16 SPY 166s put contracts • ( 16)( $235) = $3790 or 4.8% of value of portfolio • Beta hedge only • (7)($235) = $1645 or 2.1% of value of portfolio

  14. Follow up on delta neutral hedge • SPY drops 2 points to 164.62. The puts should trade at 3.30 with a delta of .57 • (7) / (.57) = 12.3. • Only 12 puts are required for delta neutral hedge so…. Sell 4 contracts @ 3.30 and remove $1336 from position.

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