The Striking Price

A Cheap Way to Hedge


Saturday, August 30, 2014

How to protect your stock portfolio from an October swoon by using an inexpensive "put spread collar."

To hedge, or not to hedge.

It's not so much a question anymore, as it is a riddle. Anyone who has hedged this year has lost money as the stock market has ground upward, shrugging off all sorts of bad juju that is normally cause for a nice big correction.

Yet talk of rising volatility, which would be accompanied by a stock decline, is starting to swirl around the Street. Investors are increasingly discussing what it means that the CBOE Volatility Index (VIX) is historically low while bearish put prices are expensive. The short answer is that investors are edgy and some are now buying defensive puts.

MUDDLING THE DISCUSSION about what happens next is a fact that all investors understand, even if they don't understand options.

Hedging stock portfolios has been one of the worst trades over the past five years as the market rebounded from the credit-crisis lows. The better trade has been buying stocks on dips, rather than wasting money on hedges that would increase in value if stock prices fell. "This will end, but when? Only the Fed knows," says Michael Schwartz, Oppenheimer's chief options strategist, who can't recall a more difficult market to hedge in his 50-year career.

Despite all the palavering about what the Federal Reserve will do, no one knows when the central bank will raise rates from their current historically low levels, or even stop buying bonds. Many people think something might happen this fall.

But this is a fact: The stock market is entering the historically volatile fall period. Major indexes are trading around record highs. Portfolio-hedging costs are historically low. Many investors have made a lot of money in the past five years since the stock market began recovering from the financial crisis.

With fall soon here, there is an expectation that implied volatility, the essence of options prices, will increase. Most of the stock market's major corrections have occurred in October. September is the month of psychological dread, and is usually even more volatile than October because volatility increases in anticipation of history's cyclicality.

Though it is difficult to recommend spending money on hedging, it is easier to suggest doing so with virtually no cost.

Stephen Solaka, a partner with Belmont Capital, a Los Angeles money-management firm, is advising clients interested in hedging stocks to use a "put spread collar."

With the S&P 500 SPDR Trust SPY +0.12% SPDR S&P 500 ETF Trust U.S.: NYSE Arca $200.96 +0.25 +0.12% Sept. 2, 2014 9:30 am Volume (Delayed 15m) : 0 P/E Ratio N/A Market Cap N/A Dividend Yield 1.87% Rev. per Employee N/A More quote details and news » SPY in Your Value Your Change Short position (SPY) at 200.35, Solaka says, investors can buy November 195 puts and sell November 185 puts. This is a classic "put spread" that investors use when they want to cost-effectively hedge against a specified decline. In this case, the hedge provides investor protection between 195 and 185.

TO FURTHER LOWER THE COST of the hedge, Solaka likes selling an S&P 500 SPDR Trust November 205 call. The call sale "collars" the portfolio and obligates investors to cover the SPY call at a higher price or sell stock if SPY is above 205 at expiration.

The traditional collar strategy involves buying a put and selling a call. The put spread collar is better than a regular collar for a moderate hedge, as the protection can be closer to market prices as the short put helps offset cost. A traditional collar would use puts that are further out of money.

The hedge's key risk is that the market is just below the 205 call strike. If that bothers you, let your profits ride. But if you want to lock in profits and protect against a decline, it's hard to beat Solaka's hedge.

Reprinted by permission of Barron's Online, © 2014 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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