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Choosing which hedge is right for you

Chris McKhann (chris.mckhann@optionmonster.com)

Today's plethora of indexes and exchange-traded funds have given rise to a wide array of hedging vehicles. These can often be the best way to buy protection on a portfolio, but not always. So how do you decide what's best for your particular assets?

A number of factors should be considered, but two of the most important are correlation and cost. One thing that makes the VIX-based funds so popular as hedges is that the volatility index has a very high inverse correlation with the S&P 500. (When the SPX goes down, especially sharply, the VIX tends to go up.)

But the structure of those products, which are mostly priced on the VIX futures and not the spot volatility index, means that they carry very high overall costs.

Most investors hold 10 or more stocks, so buying a put in an ETF makes sense if you are looking for one option to hedge your whole portfolio. This keeps the commission costs relatively low, and most diversified portfolios will have a reasonably high correlation to the S&P 500.

That's where the cost issue comes in, however, as the implied volatility of indexes and their  associated ETF options tend to be relatively high. Volatility risk is a well researched phenomenon that shows that index puts carry an "insurance premium." It can been seen as the implied volatility (:IV) of the S&P 500 tends to be above its historical volatility (:HV), as illustrated on the chart below.

Although the puts of individual company equities can carry a premium as well, that is not always the case. And when they do, they are obviously much more dependent on specific catalysts such as earnings.

The implied volatility of these options gets driven much higher going into such known events but then drops sharply afterward. It is at those lows that individual puts may make more sense than those in indexes or ETFs.

This action can be seen in Apple options, shown on the chart below. The peaks in implied volatility come from earnings, and afterward the price of the options is substantially lower.

There is even an option strategy based on this idea that produces pretty steady profits, known as  dispersion trading. It involves selling index options and buying options of the underlying stocks.

One important factor in using puts in indexes versus individual names goes back to that correlation issue. When the market sells off hard, correlations tend to go to 1, meaning that all stocks fall together--so owning index puts would work in those instances.

But if you use puts on only 1 or 2 stocks, it is possible that those equities won't go down as much as others in your portfolio. And buying puts on each of your stocks can be time consuming, confusing, and costly.

So any decisions on hedging should come down to correlation, costs, and your commitment to the asset you're protecting. If you really believe in a stock--or you don't--that should be reflected in your hedging strategy.

(Charts courtesy of  iVolatility.com )

(A version of this article appeared in optionMONSTER's Education newsletter of Feb. 6. Charts courtesy of  iVolatility.com.)

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