A Practical Guide to Hedging with Index Options
Hedging a portfolio against a market correction is conceptually easy to understand. However, that is rarely the case in practice with multiple variables to consider. We've assembled a pragmatic guide to the best practices for putting on an effective portfolio hedge. Variables to consider include timing, hedging instrument, sizing, expiration date and strike price.
Before evaluating a portfolio hedge, it should be known that the most effective hedge for a portfolio is to move assets to cash when anticipating a market correction, and reinvest when markets recover. However, moving to cash is not always an option for investors and that is when a portfolio hedge using options should be considered.
Protecting a portfolio against a market correction is best achieved by buying put options on an index that's closely correlated to that portfolio. Put options provide unlimited downside protection with a fixed predetermined cost. Simply put, it can be viewed as buying an insurance policy with a one-time premium. Put options should only be purchased during a market correction and generally should not be used ahead of time to anticipate an upcoming correction. Due to the expensive nature of hedging, it is critical that hedges are exited as quickly as possible once a market correction is complete. Timing of entry and exit of a hedge should utilize “fear gauges” such as the Nasdaq-100® Volatility Index (VXN).
Picking the right instrument to hedge your portfolio can be challenging. Most diversified portfolios should use a broad-based index as the hedging instrument. Protecting a portfolio during a market correction can be achieved efficiently using Index Options. Indices such as the Nasdaq-100 Index (NDX) provide a wide selection of expiration, strikes and contract sizes that are well suited for hedging a portfolio against market corrections greater than 3-5%.
Cash settled, European-style Index options with potentially favorable tax treatment provide additional cost efficiencies for hedging vs. traditional ETF options. NDX index options leverage the full value Nasdaq-100 Index while the NQX contact provides 1/5 the exposure to the same flagship index. These two contracts provide different notional index sizing to fit the needs of retail and institutional customers.
Determining the number of put contracts to purchase for a hedge can be calculated using the following formula:
$ Portfolio Value ÷ Index Value ÷ 100 = Put Contracts to Purchase
Example: $1,000,000 ÷ 1,470 (NQX Index Value) ÷ 100 = 7 Contracts of NQX
Index options provide a wide range of possible expiration dates giving investors flexibility in choosing the appropriate time frames. Most portfolio hedges typically last a couple of weeks to a couple of months. It's best to choose an expiration date that is at least 1-2 months beyond the expected correction period. Longer-dated options have less time decay (Theta) which helps reduce the cost of holding the hedge. Example: If an investor anticipates a 5% drop in the next month, it’s best to buy a 2-3 month option.
Investors have flexibility when choosing strike prices which provide various degrees of protection. Analogous to insurance policies, investors can choose between catastrophic or comprehensive coverage.
Strategy 1: Buy Out-of-the-Money "OTM" Puts (30-40 Delta)
Catastrophic Coverage - Provides downside protection only in a major market correction
Cost: Typically 1-2% of the underlying portfolio
Strategy 2: Buy In-the-Money "ITM" Puts (50-60 Delta)
Comprehensive Coverage - Provides downside protection with any market correction
Cost: Typically 3-5% of the underlying portfolio
Hedging a $1,000,000 Portfolio using NQX (Nasdaq-100 Reduced Value Index Options)
Catastrophic Coverage: Buy 7 Contracts, 2-Month 30-Delta Put @ $17,500 (1.75% of Portfolio)
Comprehensive Coverage: Buy 7 Contracts, 2-Month 60-Delta Put @ $36,750 (3.68% of Portfolio)
Despite ITM Puts costing more than twice the amount of the OTM puts, they provide far better protection during a correction while maintaining a smaller portfolio loss even when the market does not move lower. Only if the market moves significantly higher, does the ITM puts underperform for the overall portfolio.
Hedging a portfolio efficiently against a market correction can be achieved using index options with the correct inputs. The flexibility of Nasdaq-100 index options provides both retail and institutional investors the ability to stay invested in equities while reducing exposure during market downturns. Understanding the impact of different degrees of hedges is critical to a successful hedging strategy. Utilize the OptionsPlay Platform to visualize and calculate portfolio-hedging strategies for risk and reward metrics on your underlying portfolio.
The information contained herein has been prepared without regard to any particular investor’s investment objectives, financial situation, and needs. Accordingly, investors should not act on any recommendation (express or implied) or information in this material without obtaining specific advice from their financial advisors and should not rely on information herein as the primary basis for their investment decisions.
Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities, commodities or exchange traded products.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.