One of the biggest problems with hedging is the high cost of option protection – a fact that we talk about in our IOI 103 course on Investment Structuring. This article discusses various strategies to reduce the cost of a hedge, including:
- Using a “Collar”
- Using an ETF-based “quasi-hedge”
- Using a “cross-hedge” with a related commodity.
Collar
The most obvious and cost-effective solution is to use a structure that pairs a protective put with a covered call. The cash inflow from the covered call helps to offset some of the cost of the protective put, and the strike prices of both options can be altered to tailor the investor’s risk and return balance.
Figure 1. Collar
The diagram above looks complicated, but it’s easy if you break it down. This owner of ABC bought the stock when it was trading for $35 per share – this is shown by the red shading at the $35 mark. The stock price has increased to $50 per share, so the investor has an unrealized gain on the region from $35 to $50 – shaded in the above diagram in orange. Because the investor owns ABC, he or she owns the upside potential above $50, which is shaded in green in the figure above.
In this example, we have bought a protective put struck at $40 per share – immunizing the portfolio from a fall below that price (shown by the lower gray-shaded region in the figure above). This protective put locks in five dollars’ worth of gains (from $35 to $40), leaving the investor exposed to only $10 worth of downside exposure. A portion of the cost of the protective put is offset by the cash inflow from selling the slightly Out-of-the-Money (OTM) covered call struck at $52.50 in the diagram above. Selling the upside potential using the covered call (represented by the upper gray-shaded region in the figure above) means that if the option expires when the stock price is trading at $52.50 or above, the investor’s gains are limited, but also means that the downside protection is much cheaper.
When we initiate this collar transaction, we have no idea if the stock will be called away (i.e., if the stock price will rise above $52.50) or if we will make use of our put protection (i.e., if the stock price falls below $40.00), so the ongoing exposure post-expiration is listed as “contingent.” We are certain, however, that our investment will generate at least $5.00 per share worth of profit in the worst case and as much as $17.50 per share worth of profit in the best case.
Quasi-Hedge
The collar strategy can be executed as an overlay on a single stock position, but there are reasons why a single-stock option strategy may not be desirable or even possible – depending on tax issues or lock-up restrictions. In this case, options on ETFs come in very handy. Using options on ETFs will not provide a perfect hedge for a concentrated position, but these strategies will help your client manage “systematic” risk. Because they do not cover stock-specific risk directly, I will call these strategies “quasi-hedges.”
The simplest quasi-hedge uses a purchased protective put option on an ETF of an appropriate index. For example, a concentrated position in a large capitalization S&P 500 component might be hedged using put options on an S&P 500 index ETF. The size of this index-based quasi-hedge may be adjusted for the beta of the stock to help make the hedge more effective. For example, for a stock with a beta of greater than one, the notional size of the hedge might be made proportionally larger than the market value of the underlying position. While it is true that betas can and do change over time, durable changes in the beta usually occur gradually, so this sizing strategy is effective for managing general market-based risk.
If the concentrated position is a stock that makes up a material percentage of a sector or industry-tracking ETF, the same protective put strategy can be applied using options on that ETF. The concept of beta is valid in this case as well – beta is usually calculated with respect to an index, but can be calculated with respect to a sector or industry basket as well. Protective puts on sector or industry-based ETFs are especially effective if the concentrated stock is a cyclical name and you are worried about the possibility of a cyclical downturn.
Commodity Cross-Hedge
In other cases, options on input commodities may turn out to be a good hedging tool. For example, let’s say that you are an RIA with a client who is a grocery executive and has a concentrated position in a listed supermarket. One of the biggest threats to a grocery chain is a deflationary price environment for food. To help manage this risk, you might consider buying a put option on an ETF tracking food commodities. If the price of food does go down, lowering the supermarket’s revenue growth and profitability and dropping the share price of the client’s holding, the put position in the food commodity ETF may partially or fully offset the loss on the stock position.
Another related example might be an investor who is an executive at a Big Three carmaker and wants to manage risk on his or her concentrated holdings in the auto industry. The investor might be particularly worried about the possibility for a rise in the price of steel, for instance. In this case, a call option purchased on a steel or metals ETF will rise in value as the price of the input commodity rises; the profits from this option may be able to offset some or all of the losses on the stock position.
Keep in mind that we have presented each of these quasi-hedges or cross-hedges as discrete strategies, but there is nothing to say that they cannot be combined as well. For example, you could construct a collar on a small proportion of the concentrated holding using single-name options, then use an index put, a sector-tracking ETF put, and where appropriate, a position in an option on a related commodity as well.
Obviously, only the options on the underlying stock itself will be a perfect hedge. This means that if the company faces an issue that is specific to its operations but which does not affect other stocks in the industry or index, or if it is not related to a pricing change in the commodity complex, the quasi-hedges will likely be ineffective in laying off the concentrated position’s risk.
In the end, options are terrific tools that can be creatively used to tailor risk in a portfolio, but unless you are hedging using options on the underlying security, the efficacy of the strategy will depend on whether or not a shock is stock-specific.