Over the weekend, there was a discussion of hedging portfolios with options in my favorite column, The Striking Price, which appears every weekend in Barron’s. Steve Sears relayed a reader request to Stephen Solaka who manages money for Belmont Capital out in sunny but dry California. The question was basically, “How do I go about hedging a $1 million portfolio if I am concerned about the equity market over the near term?”
The response, formulated when the SPY ETF was trading around 211 involved buying an out of the money SPY Aug 207 Put and selling the SPY Aug 202 Put. The second part, where the option was sold helps pay for the premium paid out for the higher strike put but limits the benefit of the hedge a bit. As a final suggestion it was recommended that the SPY Aug 214 Call be sold as well.
There was no specific pricing mentioned in the article so I ran down to the trading floor this morning to get SPY and SPY option prices from the close on Friday. SPY finished the day at 210.50, close to the 211 price level mentioned above. The SPY Aug 202 Put could be sold at 0.40, SPY Aug 207 Put purchased at 1.07, and finally the SPY Aug 214 Call sold for 0.48. The net result here is a cost of 0.29 for the combined spread.
Anyone that reads our blogs knows that when I hear SPY I think S&P 500 Index (SPX) options. Taking the same idea I looked up SPX pricing from Friday. The S&P 500 finished the day at 2103.84, just a tad under 10 times the size of SPY. The SPXPM Aug 202 Put could be sold for 4.20, SPXPM Aug 207 Put purchased at 11.10, and the SPX 2140 Call sold for 3.90 for a net cost of 3.00 for the combined spread. Do note I used SPXPM option pricing since SPY contracts are PM settled.
Remember the original question was how to hedge a $1,000,000 portfolio and this is where we have to do a little math (and rounding). The recommendation in Barron’s was to use 48 SPY options at each strike. SPX is ten times the size of SPY so, rounding up a bit, the same basic hedge could be initiated using just 5 SPX options.
In addition to getting the same exposure with fewer options, SPX options are cash settled. This feature of SPX options makes them ideal for hedging situations. Therefore if the hedge pays off, which would mean SPX is below 2070 (the long put strike price), the holder of this position would receive cash. Of course the amount of cash received capped on the downside through the short position in the 2020 Put.
The same trade using SPY options would give similar economic benefits, but if held through expiration, and SPY between 202.00 and 207.00, the result would be assignment on the short SPY 207 Puts and a purchase of SPY. The purpose of this trade is to hedge a portfolio, not to buy shares of SPY, so to avoid assignment the trade may need to be exited before expiration. With SPX, the position may be held through expiration which results in cash, which we all know is just as good as money.