Taking shelter from the storm

August 6, 2015 09:00 AM

Look, everybody with any common sense knows that this long running bull market will pull back at some point. Germany’s DAX index has already entered the official “correction zone,” being 10% lower from its April 15 high at time of publication. The U.S. market will correct as well. It is simply a matter of when. Near-zero interest rates will be ending soon and the seemingly never-ending stock buyback cycle also will end.

This is not to say that you should liquidate your entire equity portfolio. Stocks remain an outstanding and outperforming asset class. Just the same, there are times that call for prudence and shelter and this is one of those times.

It is not easy, particularly for less experienced traders, to get short access to equities. Here are three ways in ascending order of complexity: A long-dated index vertical put spread; a CBOE Volatility Index (VIX) vertical call spread as a downside hedge; and a synthetic short stock.

There are a few caveats. These are not trading recommendations, all are real time examples as of June 8 of time and price specific and therefore cannot be replicated exactly. They demonstrate a way of thinking about, visualizing, a way to protect your equity portfolio.

Further, we assume a frictionless market. That means that I assume liquidity (by the way, please only trade liquid classes), I do not take account of the bid/ask spread (the single biggest cost to traders) and I do not take account of commissions or your tax consequences. 

Given all of that, let’s look at our first very basic way of protecting your equity portfolio from an unacceptable loss.

Let’s begin with a long dated out-of-the-money vertical stock put spread using the options on the S&P500 ETF (SPY). 

The Profit & Loss graph of a vertical put spread looks like this: 

Assuming a hedge against a 10% move lower, we can buy the SPY September 2015 190 (strike B) put at $2.70 and sell the September 170 (strike A) put at 90¢, for an outlay of $1.80, or $180 per spread.  At 170 at expiration (a true crash scenario) the spread makes $18.20, or $1,820 per spread for a 10x return. And, in any case, any move below our 10% target makes money. 

Next, let’s look at a more esoteric hedge against a major stock market move lower. Namely, a VIX vertical call spread.

The VIX is a CBOE proprietary index that provides a measurement of the implied volatility in the U.S. market during the next 30 days. Remember that there are two sorts of volatility, historical and implied. Historical is just that, looking backwards. Whereas implied volatility is what the market in its wisdom of supply and demand thinks the volatility will be.

Higher volatility means higher options prices as larger swings are expected. Low volatility means little is expected in the way of market movement, which is why VIX is often thought of as an indicator of relative complacency. Some people call the VIX the Fear Index as volatility tends to explode in falling markets and drop in rising markets. That means a good way to play an anticipated down move or hedge against such a move is to buy a VIX call spread.

Currently, the VIX is trading at 15.50. Its 52-week range is 10.28 – 31.06 and this indicates that there is still a relatively high level of complacency in the market combined with a relative lack of fear despite the current downticks and global uncertainty (see “Measuring fear,” above). Keep in mind that the VIX was above 31 during last October’s sell-off and at the height of the financial panic in 2009 it came close to 90. Remember, if the market goes down the VIX will go up. And if the market really pukes the VIX will roar higher.

The P&L graph of a vertical VIX 20-25 call spread looks like this: 

At the time of writing, the spread is trading at 75¢, which seems cheap. A VIX at 25 or higher on the third Wednesday of September will more than quadruple your money. And a VIX at 25 is hardly inconceivable given that it breached that level in December’s minor correction. This makes a VIX vertical call spread an inexpensive downside hedge.

Finally, we’ll move on to a more complicated shelter from the storm. And that is synthetic short stock.

Let’s say you own a stock that you like but are afraid of a mega move lower. But, your stock is tied up for tax or estate reasons or in your 401K. Using options, you can sell the stock without actually selling it. 

Let me demonstrate.

Synthetic short stock is created by being long the put and short the call with the same strike price. Not every private investor has the facility to borrow shares and sell them short in the market. Borrowing stock also means incurring extra costs in the form of lending fees. 

Let’s take Apple (AAPL) as an example. Its stock is currently trading at $128. You can buy the July 130 put at $4.60 and sell the July 2.60 call at $2.60. This position has exactly the same profit/loss characteristics as being short the stock at 128. Remember, synthetic short stock = long put, short call.

Your risk here is what we call “Pin Risk.” That means if the stock at expiration is “pinned” to the 130 strike you have a classic Hobson’s Choice. Do you exercise the 130 call without knowing if you’ll be assigned on the short 130 put? For that reason it is advisable to unwind the position the day before expiration if it looks like the stock may settle at the strike. Of course, this trade can be made to simply take a short position in Apple if you are so inclined. 

The simple buying of puts is an easy way to short an equity and one in which your risk is fixed to the premium you pay. The problem is that fixed cost is not free and traders seeking bargains by buying out-of-the-money puts need to hit a home run or risk being right the move, but still lose money. 

More importantly is the ability to protect your holdings from adverse moves. Here we presented three ways to take shelter from the coming storm.

About the Author

Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Liss has educated and mentored traders since 2006.