Creating Highly Effective Hedges With Index LEAPS

By Justin Kuepper AAA

The majority of investors place long-only equity trades in index and mutual funds within retirement accounts. Unfortunately, this majority is forgoing a key advantage of active trading and non-equity financial instruments – the ability to hedge. While hedging may sound like a complicated strategy, index LEAPS can make the process very easy for the average investor to mitigate portfolio risk.

TUTORIAL: Options Basics

Motivations for Hedging a Portfolio
Since most investors are saving for retirement, they often prescribe to the "buy-and-hold" mentality using a combination of index and mutual funds. Unfortunately, this methodology means always being fully-invested in a market that can move to the downside at inopportune times. Luckily, index LEAPS can be used to help limit the potential downside, while preserving all of the upside.

Why use index LEAPS to hedge against potential downside? Suppose that the S&P 500 has recently moved off of its low with a strong fundamentally-driven rally, but you suspect that any new interest rate decisions could put the market at risk. While you believe the S&P 500 will move higher in the long-term, you are worried about a short-term rate hike, so you may decide to use index LEAPS to limit your risk.

But why not simply buy and sell the mutual funds instead? For one, some "load" mutual funds charge hefty fees for such transactions, while transaction costs from brokers can also quickly add up. More, investors hoping to rapidly sell a mutual fund when an adverse event occurs will also find that the value of their holdings are calculated at the end of the day – so they will incur the loss anyway. (For more on loads, see Overview Of Mutual Fund Expenses.)

Hedging Your Portfolio with LEAPS
The most common LEAPS index hedging strategy involves purchasing one index LEAPS protective put that correlates to each index or mutual fund holding in a portfolio. While this may seem pretty straightforward, there are three key steps to consider when executing the strategy.

Step 1: Formulate an Outlook
The first step to hedging a portfolio is to formulate a basic outlook on the market and your holdings in particular – bullish or bearish. If you're a cautious bull, then hedging with this strategy may be a good decision. But if you're a bear, it may be a better idea to simply sell the funds and reinvest in something else. Remember, hedges are designed to reduce risk, not cover up bad investments. (For more on formulating a market outlook, see Leading Economic Indicators Predict Market Trends.)

Step 2: Determine the Right Index
The second step is to find an index that correlates to your funds. Luckily, most index and mutual fund options included in retirement plans are relatively straightforward, with names like broad index, small cap, large cap, value-based and so forth. These funds can be hedged by purchasing protective puts using common ETFs like SPY for the S&P 500 or VB for small-cap stocks.

However, there are some funds that can be trickier, and you may have to read a prospectus or two in order to determine their holdings. For instance, if you find a fund tech-heavy, then perhaps the QQQQ would make a good hedge, while a commodity-heavy fund may be better off with a commodity ETF. Again, the key is finding comparable indexes that correlate to your existing holdings.

Step 3: Calculate and Justify the Cost
The third step in creating an effective hedge using index LEAPS is calculating how many protective puts you should purchase to create the hedge, which can be done in two simple steps:

1. Divide the dollar value of your holdings by the price per share of the index.
2. Round that number to the nearest 100 and divide by 100.

Once you have the number of option contracts needed, you can look at the options table to find at-the-money puts at various expiration dates. Then, you can make a few key calculations:

· Hedge Cost = Number of Contracts x (Option Price x 100)
· Downside Protection = Hedge Cost / Dollar Value of Holdings

Finally, you can determine if the cost of the hedge is worth the downside protection that it offers at various price points and time frames using these data points.

Example: Hedging a Retirement Portfolio
Suppose that you have a portfolio that consists of $250,000 invested in an index fund tracking the S&P 500 through a company-sponsored retirement plan. While you believe the market is in recovery mode, you are nervous about recent economic developments, and want to protect your investment against any unexpected events that may occur over the next year.

After researching comparable funds, you discover the SPDR S&P 500 ETF (NYSE:SPY), and decide to purchase protective puts on that index. By dividing your $250,000 position by SPY's current $125 price you calculate the size of the hedge – 2,000 shares, in this example. Since each option accounts for 100 shares, we need to purchase 20 protective puts.

If 12-month-out 125 LEAPS index puts on SPY are trading for $10 each, our hedge will cost approximately $20,000. By purchasing this hedge, you are limiting any potential downside in your portfolio to about 8% - the cost of the option – for the next 12 months, while leaving unlimited room for potential upside, if the S&P 500 continues to rise.

TUTORIAL: 20 Investments To Know

Adapting Positions to Market Changes
Once you've purchased a hedge for your portfolio it is important to regularly monitor it to adapt to any market changes. For example, if the underlying fund moves up 20%, the original hedge that's protecting your downside from a price drop below $125 may no longer be as useful. In these cases, it may make sense to exit the hedge, sell the fund, roll up the LEAPS index puts, or do some combination of these.

There are three key scenarios to consider:

· The Fund Rises – If the underlying fund moves higher, you will likely need to roll-up your LEAPS index puts to a higher strike price that offers more protection.
· The Fund Declines – If the underlying fund declines, you may want to sell the LEAPS index puts to offset your losses, and then either sell the fund or initiate a new hedge.
· The Fund Stays the Same – If the underlying fund remains the same, you may still need to roll-out hedge to a later expiration date, if any time decay has occurred.

In the end, these adjustments will largely depend on your future outlook and goals mentioned in the first step of the process above and involve the same calculations mentioned above.

Conclusion
Using the simple three-step process mentioned above and monitoring the position over time can help investors limit their downside while leaving unlimited upside potential intact to meet their investment objectives. (For related reading, also take a look at Hedging With ETFs: A Cost Effective Alternative.)

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