Which of the following investment strategies is best suited for an investor who believes that the market will have large amounts of volatility?

Hedging strategies are designed to reduce the impact of short-term corrections in asset prices. For example, if you wanted to hedge a long stock position, you could buy a put option or establish a collar on that stock.

One challenge is that such strategies work for single stock positions. But what if you're trying to reduce the risk of an entire portfolio?

A well-diversified portfolio generally consists of multiple asset classes with many positions. If you wanted to hedge the equity portion of your portfolio, you'd have to hedge every equity position—which would be extremely costly.

Here, we'll look at how to deploy a portfolio hedge with a focus on S&P 500® Index ($SPX) put options. It's important to understand that portfolio hedging is a fairly advanced topic, so investors considering this strategy should have experience using options and be familiar with the trade-offs they involve. 

How do you value a hedge?

Effectiveness and cost are the two most important considerations when setting up a hedge.

A portfolio hedge would be considered effective if its value holds relatively steady in the face of dropping asset prices. If we're trying to hedge an equity portfolio against a market sell-off, we would expect the hedge to appreciate in value so that it offsets the drop in equity prices.

As for cost, how much would you be willing to pay to hedge your entire portfolio for a certain period of time? That may depend on what you think the market might do in the near future. For example, if you strongly believe the stock market will fall 5%–8% over the next three months, an effective hedging strategy that costs less than 5% of your total portfolio's value may be worth consideration.

Why are S&P 500 put options a good choice?

Finding a single financial product to hedge your entire portfolio in all its uniqueness could be a challenge. But if you have a well-diversified equity portfolio, S&P 500 ($SPX) put options could do the job.

Options on the S&P 500 Index are considered "1256 contracts" under tax law and offer the following benefits:

• Favorable tax treatment: Many broad-based index options qualify for 60% long-term/40% short-term capital gains treatment—meaning 60% of your gains are taxed at the lower long-term capital gains rate, while just 40% is taxed as regular income. Other broad-based index options that qualify include those that overlay the Dow Jones Industrial Average ($DJX), Russell 2000 Index ($RUT), and NASDAQ 100 ($NDX).
• Cash settlement: All index options are cash settled, which makes the position easier to manage around expiration.
• Leverage: $SPX put options have a 100 multiplier, which provides the potential to offset a substantial decline in the portfolio for a relatively small upfront cost.1 

How do you construct a portfolio hedge?

Let's say you own a $1,000,000 equity portfolio that is highly correlated with the S&P 500 index (assume the beta of the portfolio is 1.0), and you're concerned that the S&P 500 may sell off substantially over the next three months. Now assume you're willing to spend approximately 3% of the total portfolio value—or ~$30,000—to hedge your portfolio over that time (more on this below).

If the SPX is at 4,200 and the Cboe Volatility Index (VIX)—the average implied volatility of SPX options—is at ~16, then the cost of one SPX 4,200 put option that expires in approximately three months would be $11,500 ($115 ask price x 100).

For this example, we're using the at-the-money strike price to obtain immediate downside protection in the event of a sell-off. With the ~3% you've allocated for hedging, you could buy three SPX 4,200-strike put options for $34,500: $115 (ask) x 3 (# of contracts) x 100 (option multiplier) = $34,500 (excluding commissions). Each SPX 4,200 put contract has a nominal value of $420,000 (4,200 x 100 multiplier), so in order to establish a hedge that covers at least $1 million, we would need to purchase three of these contracts: $420,000 (nominal value) x 3 (# of contracts) = $1,260,000.

The table below shows how hedging would affect your portfolio value upon the expiration of the three-month SPX put options.

As you can see in the example above, not only did the hedged portfolio maintain its value during the various SPX sell-off scenarios, but it actually resulted in a net profit for the overall portfolio in the –15% and –20% scenarios. The net positive change in the hedged portfolio during those scenarios was primarily due to the higher nominal value of the three put contracts discussed above.

Additional considerations:

The perfect hedge doesn't exist, and there's no guarantee that the hedge will perform as planned. Be aware that the effectiveness of hedging your portfolio hinges on its correlation to the S&P 500 index with a beta of 1.0.

• The above example assumes that the SPX puts are held until expiration (approximately three months), but keep in mind that you can generally sell the puts before they expire if you believe the hedge is no longer necessary. If you do so, you'll likely capture some of the time value remaining in the puts, which would lower the initial 3% hedging cost.
• If the VIX's level had been higher, the cost to hedge would've been more expensive, given that hedging costs rise in line with increased volatility expectations. Therefore, if you wait for the market to sell-off, there's a high probability that the VIX will move above 16. This would cause three-month at-the-money options to be more expensive, resulting in higher put prices and making the equivalent hedging strategy cost more than ~3%. The converse is also true: If the VIX had been below 16, the equivalent hedge would've cost less than 3%.

Is it worth it?

The hedging strategy presented above provides an efficient way to hedge an entire portfolio, but is the cost worth the benefit? Some investors may take comfort in knowing that the "worst-case scenario" for their portfolio is being down ~3% for the next three months. Others may feel that establishing a short-term hedge is equivalent to timing the market and, therefore, may elect to focus on the long term.

Regardless of your opinion, understand that any portfolio protection, or hedging strategy, comes at a cost. Whether it's worth it or not depends on your view regarding how far and how fast the market could fall and if you would be able to ride out a severe decline.

1With long options, investors may lose 100% of funds invested.

Important Disclosures

Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled Characteristics and Risks of Standardized Options before considering any option transaction.

Multiple-leg options strategies will involve multiple per-contract charges. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.

Past performance is no indication (or "guarantee") of future results. 

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. Any opinions expressed herein are subject to change without notice. Supporting documentation for any claims or statistical information is available upon request. 

Commissions, taxes, and transaction costs are not included in this discussion but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed. 

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.