Hedging is the practice of purchasing and holding securities specifically to reduce portfolio risk. These securities are intended to move in a different direction than the remainder of the portfolio - for example, appreciating when other investments decline. A put option on a stock or index is the classic hedging instrument.

When properly done, hedging significantly reduces the uncertainty and the amount of capital at risk in an investment, without significantly reducing the potential rate of return.

How It's Done
Hedging may sound like a cautious approach to investing, destined to provide sub-market returns, but it is often the most aggressive investors who hedge. By reducing the risk in one part of a portfolio, an investor can often take on more risk elsewhere, increasing his or her absolute returns while putting less capital at risk in each individual investment.

Hedging is also used to help ensure that investors can meet future repayment obligations. For example, if an investment is made with borrowed money, a hedge should be in place to make sure that the debt can be repaid. Or, if a pension fund has future liabilities, then it is only responsible for hedging the portfolio against catastrophic loss.

SEE: A Beginner's Guide To Hedging

Downside Risk
The pricing of hedging instruments is related to the potential downside risk in the underlying security. As a rule, the more downside risk the purchaser of the hedge seeks to transfer to the seller, the more expensive the hedge will be.

Downside risk, and consequently option pricing, is primarily a function of time and volatility. The reasoning is that if a security is capable of significant price movements on a daily basis, then an option on that security that expires weeks, months or years in the future will be highly risky, and therefore, costly.

On the other hand, if the security is relatively stable on a daily basis, there is less downside risk, and the option will be less expensive. This is why correlated securities are sometimes used for hedging. If an individual small cap stock is too volatile to hedge affordably, an investor could hedge with the Russell 2000, a small cap index, instead.

The strike price of a put option represents the amount of risk that the seller takes on. Options with higher strike prices are more expensive, but also provide more price protection. Of course, at some point, purchasing additional protection is no longer cost effective.

Example - Hedging Against Downside Risk
  • The SPY, the S&P 500 Index ETF, is trading at 147.81
  • Expected return by December 2008 is 19 points
  • Put options available, all expiring December 2008
Strike Cost Est. Return
return (19) – put
Capital at Risk
market – strike + put
125 4.2 14.8 27.01
130 5.2 13.8 23.01
135 6.3 12.7 19.11
140 7.7 11.3 15.51

In the example, buying puts at higher strike prices results in less capital at risk in the investment, but pushes the overall investment return downward.

SEE: Options Basics

Pricing Theory and Practice
In theory, a perfectly priced hedge, such as a put option, would be a zero-sum transaction. The purchase price of the put option would be exactly equal to the expected downside risk of the underlying security. However, if this were the case, there would be little reason not to hedge any investment.

Of course, the market is nowhere near that efficient, precise or generous. The reality is that most of the time and for most securities, put options are depreciating securities with negative average payouts. There are three factors at work here:

  1. Volatility Premium - As a rule, implied volatility is usually higher than realized volatility for most securities, most of the time. Why this happens is still open to considerable academic debate, but the result is that investors regularly overpay for downside protection.
  2. Index Drift - Equity indexes and associated stock prices have a tendency to move upward over time. This gradual increase in the value of the underlying security results in a decline in the value of the related put.
  3. Time Decay - Like all long option positions, every day that an option moves closer to expiry, it loses some of its value. The rate of decay increases as the time left on the option decreases.

SEE: The Importance Of Time Value and Risk Graphs: Visualizing Your Profit Potential

Because the expected payout of a put option is less than the cost, the challenge for investors is to only buy as much protection as they need. This generally means purchasing puts at lower strike prices and assuming the security's initial downside risk.

Spread Hedging
Index investors are often more concerned with hedging against moderate price declines than severe declines, as these type of price drops are both very unpredictable and relatively common. For these investors, a bear put spread can be a cost-effective solution.

SEE: Option Spread Strategies

In a bear put spread, the investor buys a put with a higher strike price and then sells one with a lower price with the same expiration date. Note that this only provides limited protection, as the maximum payout is the difference between the two strike prices. However, this is often enough protection to handle a mild-to-moderate downturn.

Example - Bear Put Spread Strategy
  • IWM, the Russell 2000 ETF, trades for 80.63
  • Purchase IWM put(s) @ 76 expiring in 160 days for $3.20/contract
  • Sell IWM put(s) @ 68 expiring in 160 days for $1.41/contract
  • Debit on trade: $1.79/contract

In this example, an investor buys eight points of downside protection (76-68) for 160 days for $1.79/contract. The protection starts when the ETF declines to 76, a 6% drop from the present market value, and continues for eight more points.
Note that options on IWM are penny priced and highly liquid. Options on other securities that aren\'t as liquid may have very high bid-ask spreads, making spread transactions less profitable.

Time Extension and Put Rolling
Another way to get the most value out of a hedge is to purchase the longest available put option. A six-month put option is generally not twice the price of a three-month option - the price difference is only about 50%. When purchasing any option, the marginal cost of each additional month is lower than the last.

Example - Buying a Long-Term Put Option
  • Available put options on IWM, trading at 78.20.
  • IWM is the Russell 2000 tracker ETF
Strike Days to Expiry Cost Cost/Day
78 57 3.10 0.054
78 157 4.85 0.031
78 248 5.80 0.023
78 540 8.00 0.015

In the above example, the most expensive option for a long-term investor also provides him or her with the least expensive protection per day.

This also means that put options can be extended very cost effectively. If an investor has a six-month put option on a security with a certain strike price, it can be sold and replaced with a 12-month option at the same strike. This can be done over and over again. The practice is called rolling a put option forward.

By rolling a put option forward and keeping the strike price close to, but still somewhat below, the market price, an investor can maintain a hedge for many years. This is very useful in conjunction with risky leveraged investments like index futures or synthetic stock positions.

Calendar Spreads
The diminishing cost of adding extra months to a put option also creates an opportunity to use calendar spreads to put a cheap hedge in place at a future date. Calendar spreads are created by purchasing a long-term put option and selling a shorter-term put option at the same strike price.

Example - Using Calendar Spread
  • Purchase 100 shares of INTC on margin @ $24.50
  • Sell one put option contract (100 shares) @ 25 expiring in 180 days for $1.90
  • Buy one put option contract (100 shares) @ 25 expiring in 540 days for $3.20

In this example, the investor is hoping that Intel\'s stock price will appreciate, and that the short put option will expire worthless in 180 days, leaving the long put option in place as a hedge for the next 360 days.

The danger is that the investor's downside risk is unchanged for the moment, and if the stock price declines significantly in the next few months, the investor may face some difficult decisions. Should he or she exercise the long put and lose its remaining time value? Or should the investor buy back the short put and risk tying up even more money in a losing position?

In favorable circumstances, a calendar put spread can result in a cheap long-term hedge that can then be rolled forward indefinitely. However, investors need to think through the scenarios very carefully to ensure that they don't inadvertently introduce new risks into their investment portfolios.

The Bottom Line
Hedging can be viewed as the transfer of unacceptable risk from a portfolio manager to an insurer. This makes the process a two-step approach. First, determine what level of risk is acceptable. Then, identify the transactions that can cost effectively transfer this risk.

As a rule, longer term put options with a lower strike price provide the best hedging value. They are initially expensive, but their cost per market day can be very low, which makes them useful for long-term investments. These long-term put options can be rolled forward to later expiries and higher strike prices, ensuring that an appropriate hedge is always in place.

Some investments are much easier to hedge than others. Usually, investments such as broad indexes are much cheaper to hedge than individual stocks. Lower volatility makes the put options less expensive, and a high liquidity makes spread transactions possible.

But while hedging can help eliminate the risk of a sudden price decline, it does nothing to prevent long-term underperformance. It should be considered a complement, rather than a substitute, to other portfolio management techniques such as diversification, rebalancing and disciplined security analysis and selection.

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