Last week was a reminder of why it is high time to take some hard look at ones investment portfolio and decide what level of risk it contains and how best to hedge against an impending correction.

As I noted in my first article in the series of Portfolio Hedging, the best analogy for why Portfolio hedging is important is home insurance. For most folks house is their most important asset and for most folks this asset is on borrowed money! Banks require mortgage owners to carry home insurance, certainly a wise move to protect against the unlikely of scenarios playing out, partial or total loss of property to unforeseen events. As a home owner most of us are more than happy to pay the necessary annual premium, with the hope that there is never a need for actually needing for insurance to cover the cost of damages.

For AVI family, investment portfolio is now starting to become a bigger asset than the house and unlike house, Mr AVI has no portfolio insurance! Hence, about couple of weeks back I decided to look into ways in which I could insurance AVI family portfolio against an impending market correction! Insurance by definition costs money.

This week I am going to take a deep dive into using options as a hedging strategy as I continue on my quest to find the best path to implement a Portfolio hedging strategy that makes most sense for AVI portfolio.

The first step in the process of exploring the options based hedging strategy was for me to figure out what index fund most reflects AVI family investment portfolio. The chart below shows the evolution of AVI family holdings and overlayed on top is the iShares Core S&P Small-Cap ETF, ticker: IJR, which tracks the S&P SmallCap 600 index. As can be seen from Figure below, the correlation of AVI portfolio with IJR is striking.

Step two is to estimate estimate how to use IJR as a hedge instrument for AVI portfolio. Here in, the concept of put-option is essential.

Option is a type of a derivative trade, where in one does not purchase or sell the underlying instrument directly, rather one purchases (or sells) and IoU agreement to purchase (or sell) the underlying instrument at a certain price at a given date in the future. This IoU agreement comes in two flavors, the so called call-option and the so called put-option.

A call-option is a contract on a given underlying instrument, say a stock, that if purchased, gives the purchaser of the option the right to purchase the stock at a given price (called the exercise price) at any time prior to or on the given date in the future (called the expiry date). If one is bullish on an underlying asset, this trade allows the purchaser to lock in a lower purchase price for a small premium, called the option price.

A put-option on the other hand is a contract that gives the purchaser the right to sell the underlying stock at a given price at any time prior to or on the given date in the future. Put option is an instrument of use if one;s sentiment on the underlying security is bearish. For a premium, the owner of put-option contract locks in the price at which he/she can sell the underlying asset in the future. In that sense, put-option can be considered a hedge against future losses, and if used appropriately can serve as a portfolio insurance tool.

It should be noted that option contracts are always traded in a block of 100 shares of the underlying security. That means, should an individual buy (or sell) one option contract, he/she will have the right (or obliged) to trade in a block of 100 shares of the underlying security.

One more concept to understand is the difference between an in-the-money option vs. out-of-money option. Every option contract is compose of two price components: (a) intrinsic value, the value of option derived from the difference in the stike price of the option and the stock price in the market and (b) extrinsic value, which is derived from the expected volatility of the underlying security and the time remaining for the option contract to expire.

An out-of-money option has no intrinsic value and all the pricing for the contract is derived from the extrinsic value of the option contract. In the case of a put-option, an out-of-money put option, comprises of an option with strike price that is below the security’s market price. It is obvious, why this is the case! Why would anyone want to exercise their right to sell underlying security at a price below the market price of the security?

With this very brief introduction, I can now talk about how I could use put-option on IJR as a hedge against future downturn in AVI-portfolio.

Let us begin with the assumption that I want to hedge AVI portfolio worth One-Million Dollars. At current price for IJR, trading at about $71 per share, I will need to purchase: $1000000/($71 x 100) = (approx) 141 contracts of IJR- put option.

Looking about a month out, slightly-out-of-money IJR put option is available for an ask price of $2.45 per contract. Total cost to purchase 141 contracts therefore is, 141 x $2.45 x 100 +0.75 x 141 = $34,650. I have included the transaction cost for option trade, assuming it costs 75 cents per contract trade.

The insurance costs about 3.5 % of portfolio for protection, for a duration of approx one-month and the table below offers the key levels of protection this put-option hedge offers:

The break even price for this trade is an increase in the underlying stock price to $73.45 (about 1 % increase), at which point the cost of option will be covered. Should the stock fall below $70, prior to the contract expiry date, the insurance kicks in and the trade actually becomes profitable, should the stock price fall below $68.55. This is also the price at which, I as an individual deciding to hedge would be happy I followed through with this trade.

Three points worth noting about the put-protection trade:

• Above calculations assume a perfect 1.0 correlation for the index-ETF, in this case IJR, to AVI-portfolio. As is evidenced from the chart above, while close to 1.0, the correlation of IJR to AVI-portfolio is not exactly 1
• The protection, if executed, would be in place only for about-a month. And if the underlying stock remain range bound between $68.55 and $73.45, the above hedge will most certainly cost money.
• Assuming one could roll over the hedge once it expires, the annual cost for the protection would be a whopping, $415,800, or about 41.5 % of the portfolio. To put this in perspective, home-insurance cost for a $ 1 Million house, in our neighborhood would range anywhere from $1000 to $2000 annually.

Given the high cost involved in a pure put-option hedge strategy, what are ways in which one could reduce the cost of insurance, at possible the cost of limited upside gains?

Collar trade is one strategy that can be leveraged to reduce the cost of hedge!

In a Collar trade, in addition to purchasing slightly out-of-money put-option contracts, the Portfolio-Manager also sells equal number of slightly out-of-money call option contracts. Let us continue with above example, and see the costs involved in a collar trade to hedge AVI portfolio of value $1 Million.

As above the trade will involve a purchase of 141 put contracts, at a price of $34,650. In addition, collar trade will involve selling equal number of slightly-out-of-money call options for IJR. Oct 16th call option for strike price of $73 are trading at a bid-price of $1.35 per contract.

Net proceed from the sale of this out-of-money call option: 141 x $1.35 X 100 – 0.75 $141 = $18929.25.

The net cost for the trade: $34,650 – $18929.25 = $15,720.75

This insurance costs about 1.5 % of portfolio for protection, for a duration of approx one-month and the table below offers the key levels of protection for the collar trade

The break even cost for this trade is the original price of the stock at which this trade was initiated, plus the $1.10 paid to initiate the collar. For stock price above $73, the short call option will be exercised and the index equity will be sold for $73. From $70 and below the position is hedged using a put option and the maximum loss suffered will be, $2.10 or $ 1 from the stock price decline and $1.10 from the cost of collar hedge.

As is clear from the table, the cost of hedge is substantially reduced (45 %) with collar trade at the cost of limit to upside potential. In general, if the potential for downside is high, collar offers a viable alternative to buying a put option.

Still rolling over the hedge to a annual time period will cost (in the worst case) upto $188,640, by no means a trivial amount!

In summary, hedging a portfolio using put option strategy can work very well in situations where one can assign a relatively high probability for a significant market downturn in the near term. Put option (and its variant in the form of Collar) may not be an ideal permanent hedging strategy as the costs for hedge add up significantly on annual basis.

In next article, I will explore additional portfolio hedging strategies, such as Spread, and its variants!

Video/Book/Article/Audio for the Week

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