Hedging on the Cheap

There are ways to safeguard a stock portfolio while keeping options-related trading costs down.

As stock indexes sag under dour European economic news, investors are turning to the options market to hedge their portfolios.

A simple strategy can be used so investors will not feel like they are buying fire insurance in an inferno.

By buying one bearish put, and selling another, investors can lower hedging costs, and still protect their portfolio from big declines.

With the SPDR S&P 500 Trust (SPY - News), a popular exchange-traded fund, trading at about 114, investors can buy the October 114 put, and sell the October 108 put. The position cost $1.91 compared to $5.07 for just buying the SPY October 114 put.

We do need to point out that in return for hedging at a lower cost, investors limit the effectiveness of the hedge. The spread strategy — selling one option and buying another with a different strike price — offsets losses to 108. Buying a solo SPY put offers unlimited downside protection.

Still, the spread's maximum return is 200% if SPY drops from 114 to 108.

Investors who expect sharper declines can buy a stand alone option contract, like the SPY October 114 put and pay the extra money. If you think the stock market's decline will not be catastrophic, use the spread strategy. Such conversations about hedging and pricing are occurring all over Wall Street.

Institutional investors — hedge funds, pension funds, mutual funds, and others — are asking trading strategists how to cost-effectively protect their portfolios. They are being told that customized hedges can be created for little cost in the "over-the-counter" market that banks operate for their best customers. Barrier options, which his a popular institutional hedge, pay off if the Standard & Poor's 500 Index falls to a certain level determined by the client.

"While barrier options don't provide crash protection, they do offer a low cost way to position for downside within a range and can lower implementation costs by 80% to 90% versus vanilla puts or put spreads depending on the volatility environment," Krag Gregory, Goldman Sachs' volatility strategist, advised clients early Monday.

Gregory is also telling clients to consider buying October 40 calls on the Chicago Board Options Exchange's Volatility Index (VIX.) With VIX at about 39, the VIX calls pay off with VIX at 40.

Since the VIX, the stock market's so called fear gauge, tends to climb when stock markets fall, this is another way to hedge a stock portfolio.

Trading VIX options can be tricky. Many investors intuitively think VIX options are based on the widely quoted VIX fear gauge, but they are based on VIX futures. Anytime you buy VIX options, you are expressing a view that VIX futures will rise or fall in support of your investment thesis, and that the fear gauge will be higher than the VIX strike price at expiration.

To be sure, market conditions are dour. If the Standard & Poor's 500 index breaks 1,140 — it was recently at 1153 — some technical analysts think the index could drop to 1,000. This is why hedging is a hot topic, and why it is worth thinking about the return of capital versus the return on capital.