Hedging with ETFs is a valuable strategy for mitigating the risk of significant moves in an equity index. A simple example is as follows: Let’s say you have $10,000 invested in the index. The current price is $1225. If you were to buy call options on, say, Apple Inc., your upside would be capped at $1325, and your downside would be $1000, i.e. less than your original investment amount if Apple stock doesn’t move at all or even goes down by 2%. Think about how powerful this could be given that positions can get bigger and smaller depending on individual circumstances and goals. This article will provide a step-by-step guide on how to do just that.
Buy an ETF that tracks the index you are hedging
Ideally, the first step would be to buy enough shares of a fund tracking your index of choice. For example, if you were looking to hedge with SPY (ETF Trust), buying ~$60k worth of SPY would make sense given today’s market price, which corresponds to about 100 shares at $64.71. Here are some examples of other popular indices, along with some funds you can consider investing in:
- NASDAQ 100: QQQ
- Dow 30: DIA
Buy a put option that matches the expiration year and strike price of your call option
If you were going to buy a call option giving you the right to purchase a stock at a fixed price, you should choose put options with the same characteristics. In our example, we would have bought ~$60k worth of QQQ in January 2015 60 Puts for about $3.85 each given today’s market prices. These options give us the right to sell 100 shares of QQQ anytime between now and Jan 2015 at $60 per share. This means that if QQQ’s price goes to $20 and we exercise our option, we will receive $60k – $20k = $40k. Otherwise, we can simply let the option expire worthless for a net loss of $3.85 per share.
Calculate hedge ratio
The hedge ratio is calculated as follows: Hedging ratio = Market Value of Futures Contract / Original Investment×100%. So if your original investment was worth $10,000 and you bought five options expiring Jan 2015 at strike price 60, you would have a hedge ratio of 10% ([$50000/($5000*10)]) or ~0.1 for short. This means that any loss or gain will be mirrored by a 10% loss/gain in your portfolio. We recommend having at least 5%-10% of your portfolio hedged with options depending on risk preference.
Monitor your hedge ratio daily
Your hedge ratio is a critical statistic that will help you maintain proper “risk parity” between the value of your futures contract and your overall investment accordingly. If, for example, QQQ goes up by 15% over the next month, it would make sense to sell another put option to offset some of this increase. You should monitor your daily performance figures such as SPY’s open, high, low and closing prices along with the corresponding changes every day and recalculate accordingly.
Assess the VIX index to gauge risk appetite of market participants
It is also essential to monitor how risk-averse market participants are feeling by looking at the VIX index. If it’s high, there’s likely to be a lot of put buying in the market, which would increase the value of options and hence your hedge ratio. On the other hand, if it’s low, you might want to consider hedging less aggressively, given that investors may feel more confident. We call this strategy an “S&P 500 Put Write Strategy”, which means simply writing covered calls on SPY to increase gains over time since there is no upper bound on how much SPY can go up. The risk is that a significant one-day drop in SPY’s price may not be fully offset by the value of the call options you have written, so it’s essential to monitor market conditions and hedge accordingly.
In conclusion
ETFs are a trendy investment tool due to their ease of use and transparency. By using them as a hedge against your portfolio, you can reduce your risk without having to go through too much trouble. Given the right circumstances, it’s also possible to make simple strategies such as ” S&P 500 Put Write Strategy” quite profitable.
