Overusing Options to Hedge

Using Options To Hedge Tail Risk

Using options to insure against large moves against large market exposure has been a strategy which institutional investors have used for a long time, and is also sometimes used by individual investors. The idea here is to take out options in the opposite direction from one’s position, usually buying put options to hedge long positions, so that one may become protected so to speak against large moves against one’s positions.

Typically, one will be long the stock market where it may be rather impractical to liquidate one’s positions during a bear market, or one may instead simply choose not to do so and hedge instead. When we hedge though, we need to be clear on the fact that this is the best way to insure against losses.

There certainly is a need to manage downside risk with any investment or investment strategy, so this is really not about whether we should do so or not. It is more a matter of choosing the right protection, one that will protect us enough and also provide protection that is also cost effective.

Hedging with options can seem to be a fairly cheap strategy, but we need to put the costs in the perspective of the expected returns of the investment in order to be able to decide how cost effective it may be.

For instance, let’s say you’re looking to hedge against more than a 15% drawdown in your stock positions. It costs you 4% per year to do this, a typical amount, and you only expect a return of 8% a year on average, a typical stock market return.

Half your expected return is given up for this insurance, and therefore it ends up being pretty costly in relative terms. It might still seem like a bargain though if you want to shield yourself against bigger drawdowns than this, but if you’re not planning on selling anytime soon and you really are married to the buy and hold strategy, this might not matter to you.

Who Needs to Hedge This Way

If you are an institutional investor though it certainly might make sense to do this, as the money you manage is going to be more subject to being cashed in at various times and you of course have to report your performance each quarter, and your job may even be on the line if the numbers don’t come out well enough.

In a real sense, some of the hedging at least occurs as a means of saving face for money managers, who can attest to taking advantage of insurance should significant bear markets occur. The costs, while significant, can be chalked up to the need to manage these risks, and there are going to be less good alternatives to do so than individual investors have, due to it being much more difficult and expensive for institutions to reverse positions.

Regardless of the motivation behind hedging with options, it it not difficult to see that there can be a real need for certain institutional investors to want to hedge this way, although there still may be a tendency to over-rely on this type of hedging. Even among institutions who cannot trade anywhere near as easily as individuals can, there still is a strong bias toward holding investments over liquidating them in a lot of cases.

If liquidation is the more cost-effective way to go, as it sometimes is, or relying on liquidation to some extent in order to reduce the need to hedge with options ends up making more sense, then we should go with the better choice or better mix here, but if we have too much of a bias toward holding, this can go relatively unexamined.

This phenomenon does occur with individual investors, who often will be biased even more toward holding, and in fact the kind of selling that really drives bear markets is done by institutions much more than individuals, who usually just sit back and moan and hold tight as they watch these bear markets unfold.

This is not to say that hedging with options doesn’t have its place with individual investors as well, especially since most or all of their holdings aren’t really effectively hedged properly, if at all. There usually is no real attempt to manage risk at all with individual investments, and there is usually very little risk management going on with the mutual funds they usually invest in heavily either, so they do need to do something.

Looking at the Cost of Holding

The cost of holding an investment is reflected in the amount of risk that a given strategy takes on. True buy and hold strategies do not limit risk at all, by definition, as the goal is to just hold the investment no matter what happens, and this cashes out to unlimited risk, up to losing the entire investment if it drops down to zero or it is hedged in any way and drops to where the account balance becomes zero.

Should one desire such a strategy and wish to hedge against it with put options, that can seem like a great idea, but we need to realize that even long options do have expiry dates and the events that trigger the drawdown may end up dissipating.

The greater the risk for a bear market, the higher the price of these options will tend to be, and when the bear market is already underway and looks like it will be sustained, options sellers are of course going to demand more premium because they are exposed to greater risks.

Those who sell options tend to have a view of the market that is much more sophisticated and knowledgeable than individual investors, and what they really need is to buy this protection before the big events happen, before the price goes up a lot, perhaps rendering the hedge uneconomical.

Even long options expire, so while you may offset some of your losses with a put option that well surpasses the strike price, when it expires, what will you do then? Will you buy another long option and have to wait another 15% or more before it kicks in and protects you further?

Meanwhile, your positions may continue to decline and unless you’re going to trade put options much closer to the market, you’re going to need another big dip to cash in. Individuals aren’t really set up to trade close to the money options even if they did have the desire to do so, as this requires real trading skill, and they usually don’t want any part of this anyway.

If you could buy very long term puts, running for 20 or 30 years for instance, the cost would be very prohibitive, as who would want to take on such a risk on the other end of this trade without being very well compensated. This is where options hedging differs from insurance, as options are really shorter term insurance contracts, which have to be rebought, where you can generally get insurance renewed quite easily at a similar cost.

Aligning Options Hedging with Investment Objectives

Should one look to hedge with options, this doesn’t all mean that this is a bad idea or even that it wouldn’t be the best way to go. A lot of whether this makes sense or not has to do with one’s investment objectives though.

The first thing we need to take into account is whether the investor has any intention of cashing out the investments that are sought to be hedged during the life of the hedging, and in this case, the life of the option.

If so, then hedging with options can make perfect sense in a lot of cases, because when you cash in an investment, it’s price will matter and matter a lot. Perhaps one should not even expose oneself to these additional risks of the market if the investment is going to be cashed in this soon, but if one does choose to do this, then having to liquidate it at a large loss if the market moves against us during this time is not going to be something we probably want to see happen.

On the other hand, if the intention to sell is far off in the future, we may rightfully wonder why this should matter so much. Sure, options hedging can take the bite out of some big bear markets, and fortunately we do have to take the profits from the decline as the option expires, provided that it does stay in the money at expiration.

If it does not, and the market comes back enough during the life of the options contract, we may end up with no profit from the option and still be down significantly in our main positions. While we may tell ourselves that we were still protected and the drawdown during the life of the contract wasn’t significant enough in the end for the protection to kick in, this does bring to light that this protection has a timing element to it.

One could be subject to a fairly large drawdown during the life of an options hedge but not enough for the option to end up below its strike price with a put option, then we buy another put, our position goes down quite a bit but not enough during the life of this contract, and so on.

From this we can see that options hedging does protect us from drawdowns but only in certain circumstances, when the timing of the drawdowns corresponds to the strategy.

The benefits when we’re far away from our intention to sell our investments are therefore going to be fairly transient, and this is not like normal insurance to be sure.

The costs of this are going to be real and significant though, so when looking to hedge in a much shorter time frame when the price of the assets will really matter, we do need to be careful not to spend too much on hedging, or perhaps even give hedging too much weight and concern.

There are other ways to hedge besides using options, especially if we are not familiar enough with the intricacies of options, in order to have a good enough idea to do a real cost and benefit analysis. When we do so, we also need to be comparing the costs and benefits of other hedging strategies, and this can all be pretty complicated and well beyond the means of armchair investors to be sure, even to the extent of having a good idea of what we are doing here and what the best approach may be.

The fact that institutions use this form of hedging has more to do with the lack of ease of turning around their positions, but individuals are under no such market constraints. There may be psychological ones though and these can be pretty constraining indeed, but the best way to hedge may simply be to look to manage risk by simply not choosing to expose oneself to greater risks than one is prepared to take on.

This does involve looking to time the market to some degree, but it really doesn’t take that much skill to decide how much risk we want to take on in an investment and just place limits on your positions. This is a hedging strategy that can be executed with very minimal costs, the commissions involved, without paying any premium beyond that.

Should one want to delve in options as well in looking to limit their risk, this can be done effectively but not without at least a good understanding of what is being bought, what it costs relative to your expected returns, and whether it is worth it or whether there are better alternatives.