Options, particularly put options, have a big role in risk management. In this video we discuss how S&P 500 put options can hedge risks and how much it costs to employ put options to hedge risks.
How to Hedge a Portfolio With Options
In the past few weeks we’ve been talking a lot about portfolio scenarios related to the news. However whenever we talk about China, currencies, oil or silver, we’re talking about the effect they have on markets; essentially equity market moves. So with this in mind, let’s take a look at what happens when you hedge a portfolio with some options, or a short ETF.
In order to make moves yourself, or on behalf of your clients, it helps to have a primer, or a podcast, on how all this works.
A put option gives you the opportunity to profit when the market falls, so you get protection on the downside. When you buy a put at a certain price on the S&P, right now at the time of writing it’s 4000, if it falls 10% to 3600 you’d be able to profit from that fall.
You’re paying a small premium for that option. Similar to an insurance premium it is for a period of time, a month, a week, a year. Basically it gives you the right to sell at a certain point.
Something similar, but with different risks, is a short ETF. If you buy one on the S&P 500 right now you can sell it when it gets lower and make a profit, because when it goes down the price of the ETF goes up. It works like a normal ETF but inversely
The main difference between a short and a put is the amount you are risking. The former you can lose a lot, the latter only the amount you put in. However you can overpay for an option. For example right now when everything is going up, it might be better to buy an option rather than when the market is volatile; because sellers are not stupid and you could end up paying a hefty price.
One of the main inputs into option prices is volatility measure. Volatility is a key pricing for options. With options you tend to pay a little more for protection on the downside than you do for participation on the upside.
This is something specific to an option. Where you price an option and you can imply what the volatility is. Then there is a volatility smile which means for different prices implied volatility is different, which is strange. It is known in financial circles as the wrong number to put into the wrong formula to get the right price. There are of course smart people trading options, but often the theory behind a lot of it is overly simplistic, and makes too many assumptions, for the real world. So people use implied volatility as a stop gap, they know the formula doesn’t really work but they adjust some other number to make it work. If it doesn’t work here, move the volatility over etc.
When you trade options, you need to think about how this implied volatility model is essentially the cost of an option. Despite what the term volatility might suggest, it’s not about that, it tells you the cost of an option. These pricing models often don’t have applications in the real world or financial markets. The 2008 crisis, for example, would have been impossible according to some of these models.
Take Your Time With Options
You’re going to pay more for a long dated option than a short dated option, because you have more time to cash in essentially. The longer you go the more chance the price will fall and ‘the insurer’ will have to pay. If you insure a car there’s more chance something will go wrong, the longer the time period.
To get a more in depth analysis of put options, listen to the entire podcast now, which includes specific examples of portfolio risk models.
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