Using Options as a Hedge Against a Bear Market

Options

While the stock market marches on, many institutional investors worry that it may be over soon. Using options is one way to contain this risk, but is it a good way to do it?

With the S&P up 22% from its recent lows, many investors are happily hanging on to their stock positions. Most investors are in it for the long term, and aren’t even that scared of real bear markets, let alone hypothetical ones.

We can always enter a bear market though, and we do need to ask ourselves what our plans are if one does come, and it always comes sooner or later. To think that this long rally can go on forever requires us to turn a blind eye to history, as we’ve seen many bull markets over the years and they have all ended.

The go-to hedge against these things is to diversify one’s portfolio so that when the stock market does come down, it will hurt less. Sure, this means that we will profit less as it rises, but that’s the price you pay for this strategy. The idea here is to keep only a certain percentage of your portfolio in stocks, with the rest held elsewhere, typically in bonds.

The main problem with this strategy is that it is not distributed according to degrees of risk, and treats all market conditions the same, with the big bull markets being treated the same way as stock market crashes are.

Another strategy, one that is not used anywhere near as often, is buying put options on the market to offset your long positions in stocks. Does this strategy have real merit, and if so, in what circumstances?

Options do have the advantage of an efficiency of sorts, allowing us to draw the line in the sand where the option kicks in and starts paying us fairly far out there. If we approach options this way, they can seem like a form of insurance, and they can be indeed set up to function this way.

Put Options to Hedge is A Fairly Recommended Option

Oppenheimer’s Michael Schwartz, one of the most highly regarded strategists on Wall St., has recently spoken on the virtues of the SPX options hedge. It is hard to argue that this cannot be used to protect investors against the big stuff, even though, like all insurance, it does result in a reduction of returns. That’s the price you pay with any fixed hedge though.

There are some good formulas out there that allow for investors to calculate just how big they need to go with buying put options to use as a proper hedge. There will be some variation as far as needs go, as people’s risk tolerances differ, but we cannot expect individuals to manage something too complicated, and the principle of simpler is better definitely applies to these investors.

For those who are willing to participate in this, what we’re looking to do with this hedge is to cap our risk exposure, our potential losses in other words if things go too far against us. If, for instance, you are comfortable with a 10% drawdown, and we need to realize that we are talking drawdowns here not losses, then we can seek to balance off our losses with gains in the value of the options we’ve bought.

It might seem peculiar that we would pay a premium to bet in the opposite direction to the one we’re hoping for, but for those who are required to hang on to their positions, directors of companies for instance who find themselves in this situation, then some sort of insurance is needed.

In a case like this, you are really backed into a corner and do need to defend yourself with something. Long put options on the market are a pretty good defense actually if you do need one.

For the vast majority of investors though, a strategy like this may not make as much sense, but this all comes down to what else we may be prepared to do in order to defend ourselves. If we asked a child about this, they might ask us why we don’t just pull back when we get worried about bear markets or are in one, and this is a far better question than it may appear to be to most people.

We Need to Measure This Against All Good Alternatives

The strategy of using options to hedge therefore has to stand not only against doing nothing or using a fixed hedge with a certain percentage of your portfolio in bonds all the time, it also has to stand up and be measured against active hedging.

In a sense, the investment industry has convinced us that we are locked in the room and therefore must make plans to protect ourselves within these confines. We’re told things like stay the course, don’t sell when things look bad, don’t try to time the market at all, and so on.

When we buy options to hedge though, we are timing the market, at least if we’re looking to do this strategically and not all the time. We are also taking an active role in our investment management with this, something else that is strongly discouraged. If we’re willing to go this far, we should at least consider what else we may do instead.

Insurance costs real money, whether it be insurance that you buy from an insurance broker or put options you buy from your financial broker. There is no free lunch in the financial world, and the expectation with this is that you are going to be losing money with it, even though it may benefit if we need it, but only if we actually do. In the long run we’re looking at a losing proposition.

Let’s take a scenario where you do not want to be down more than 10% with your long stock positions. We could set up an options hedge, where if we do go down more than that, additional losses will be covered by profit from the option. We’re neutral below this point in other words, similar to our just exiting our positions, as long as the option is in play that is.

When it is exercised, we’ll have to buy new options, and we can’t just buy them cheaply right at where the market is now, and we’d be better off actually just shorting the market straight up with something like index futures. What they don’t tell you is that this strategy has a limited window, the briefer visits by the bears, and isn’t particularly good against the longer ones.

This is because we’re going to need to keep resetting things and taking a hit each time we do, which involves the distance between the current price and where we want to buy the put at, which will be considerably lower and therefore cause another gap. This can be managed with more sophisticated techniques, but only somewhat.

We can instead choose to just sell everything once we reach our level of tolerance. There are only two differences between these strategies. When we don’t decline that much, which will usually be the case, we lose the price of the option. The second difference is that we don’t have to get back in if we use options, as we’re always in with this strategy.

We ignore the first option because we don’t like the second option very much. This is what we are actually paying the price for, to be able to avoid making decisions about exits and re-entries. The exit part here is determined by our strategy, but the re-entry part of it is not, and we’re on our own with this one.

Unless we are prepared to step up to the plate with strategic hedging, which always requires us to decide if and when to activate our hedges and pull back, and when to start loading up again, this strategy is not for us. If we are recommending things that people are just not comfortable doing, they will not take our advice, nor should they.

If we are willing to use options strategically to hedge though, it’s not a big step to use bonds that way, and we can shape this hedge to accommodate whatever hedging needs or wants we have. If we don’t want to do this, we need to simply be willing to pay the price for the alternatives, and the price of them is clearly higher.

When we really get to the heart of the matter, hedging with options may not be optimal or even close, but they may indeed be optimal given the actual range of choices that people may allow themselves. If done right, this can have some advantages over doing nothing differently in the face of more risk. Strategic hedging is best, but only if we wish to do it.

At least option hedges do give us an outlet to express ourselves, and feel like we’re doing something during times of worry where it makes more sense to use something like this. The benefits of this extend beyond financial ones, as this can also convey the peace of mind that they aren’t just forced to take whatever losses come during a bear market.

If you’re going to hang on to your stocks come what may, you have put yourself in a position where you need protection, and choosing protection over none is a good idea generally, including in this case. For those who wish a more effective way to manage these risks, keeping more of your money in stocks during the good times and less or even none during the bad times is always an option as well.

The door to our room isn’t unlocked at all, but we must wish to go through it or we will indeed need to stay down when the bullets start flying.