Hedging with Options

Journal of Financial Planning: January 2021

 

Ryann Marotta, CFA, CFP®, is a senior portfolio manager at Austin Asset Management, a boutique wealth management firm committed to authentic advice. In her role, she develops relationships with clients to understand their unique situations and structures investment plans to support their needs.

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Do you have an investment risk in need of hedging? Not to worry, you have options! Options are quite literally the equivalent of investment insurance.

Options are increasing in popularity as evidenced by the explosion in contract volume since the turn of the century, having increased from less than $1 billion contracts cleared annually to more than $5 billion cleared in 2018.1 While this can be attributed to increased efficiency and access due to technology, growth among retail investors is also a factor as new trading platforms push the practice. As financial planners, we know this is not the place for the inexperienced. Options trading requires education, due diligence, and a thorough understanding of clients’ objectives.

Working in the Confines of Risk, Return, and Reality

Financial planning as a service is essentially personal risk management, and financial planners are the risk managers, carefully calculating the tradeoffs between the various types of risk and the need for return to achieve a defined objective.

As financial planners, we strive to mitigate risk for our clients, helping them determine an appropriate savings plan and asset allocation to meet their long-term needs. In doing so, we build a portfolio that attempts to diversify away unsystematic risk associated with a particular industry or security to withstand short-term market downturns and the occasional corporate misstep. As this portfolio grows, it also serves to hedge against longevity risk and inflation risk. In effect, we invest to insure our financial future.

However, rarely are we provided a fresh start from which to construct a tidy financial plan, and thus, we must work within the confines not just of risk and return, but the fiscal ability and emotional willingness of the client to accept changes to risk and return in their best interest. And, while we know financial markets go up over time, we also know this neither happens all the time, nor with every stock. Therefore, in addition to breaking down behavioral biases through education, we must also help clients protect against poor timing and bad companies.

Today, there exist many investors who are unintentionally overexposed to market risk. Not only did 2020 witness the end of a historic bull market, but also the birth of our newest bull market. Not even a global pandemic, combined with a hotly anticipated presidential election, could suppress stock markets for long, as 2020 is now recognized for the shortest bear market in U.S. history as measured by performance of the S&P 500.2 During this period, it is not surprising to come across clients who have amassed a significant portion of their wealth in a single market, sector, or stock. As planners, we must determine how to ensure that their concentrated risk does not impact their long-term goals.

To Hedge, or Not to Hedge?

At what point does concentration require hedging? As goes the common risk manager’s response—it depends. I recommend approaching the question as we do all concentrated assets. First, determine what percentage of your client’s overall liquid investment portfolio is comprised of the concentrated asset. Second, consider their long-term needs relative to the portfolio with and without the concentrated position. Would an Enron-level catastrophe significantly impact the client’s likelihood of financial success? If so, insure!

For example, consider two different clients who are expected to live 30 more years:

  •     Client 1 has 60 percent of their $20 million liquid portfolio in stock ABC and draws $150,000 per year;
  •     Client 2 has 50 percent of their $10 million liquid portfolio in stock XYZ and draws $200,000 per year.

While both clients could benefit from options hedging, Client 2 has a greater need.

In contemplating hedging, it is important to realize that the same principle of risk and return applies. When buying option contracts to hedge financial markets, you are buying protection for a defined risk. However, since expected return is positive over time, the cost to insure reduces the expected return on the off chance of financial catastrophe when the money is most needed.

In addition to hedging risk from a specific stock, options provide means to hedge broader market risk through options on exchange-traded funds (ETFs) following indexes or sectors. These options follow the American style and trade, just like those for stocks. However, there are also options for indexes directly that trade according to the European style, meaning they lack the ability to execute early and settle in cash at expiration.

Breaking Down the Basics: The Protective Put

The classic option hedge is the protective put, which almost 80 percent of independent registered investment advisers (RIAs) report using in their practice.3 The hedger buys put options to protect against a loss in value of a long stock position. A put buyer buys the right, but not the obligation, to sell the underlying stock at a predetermined price, the strike price, any time before expiration. Therefore, should the stock drop in value, a put owner can sell their stock at the strike price, thereby locking in a floor value insulated from further decline.

The insurance metaphor extends beyond the straightforward objective of protecting against the loss in value of a stock. The cost of the option can be considered the premium paid for coverage, which similarly varies based on value, duration of coverage, and the underlying riskiness of the asset. The difference between the strike price and the current market value can be considered the deductible—the amount you’re willing to come out of pocket before coverage kicks in. As opposed to a fixed dollar amount, it is best to consider this as a percentage of the value. Based upon the client’s ability and willingness to accept loss, determine a suitable percentage downturn that the client could withstand.

While this may sound straightforward, the reality proves complicated. Since the need to hedge derives from the outsized value of the position relative to net worth and need, the cost will undoubtedly be high if looking for full coverage indefinitely. Therefore, consider your options.

Revisit the needs analysis to determine if partial coverage will suffice. The more flexible the need, the more creative you can be to help mitigate costs. First, consider the various levers available with simply constructing the protective put. As the coverage need decreases, the number of options contracts can be reduced. Or, is the client willing to increase their deductible to offset costs, thereby accepting a lower strike price? Or, perhaps they might be willing to stagger their strike price, accepting a bigger potential loss on only some of their stock position. Lastly, rather than long-term coverage, can the time frame be targeted to insure against a negative outcome from an upcoming event like an earnings announcement or a competitive contract bid?

An additional characteristic of options is the value they hold. As the underlying stock of a put option falls below the strike price, the put option is in the money and becomes more valuable. As the option buyer, you hold the right to sell the underlying stock up until expiration, thereby retaining control of the position, unlike a stop-loss order. That option has bought you time to further weigh risk and return tradeoffs up until expiration. The decision to implement a hedge differs from the reality of the hedge once in the money. If a behavioral bias affects the client’s willingness or a capital gain the client’s ability, there remains the option to sell your now valuable option. This potential opportunity for profit can help offset the initial cost and even the depreciated stock value.

More Options, More Ways to Hedge

Consider additional options positions to overlay with the protective put to create a collar or a bear put spread. Both of these option strategies require selling options contracts, thereby deriving premium income to help offset the costs of the original protective put. When selling an option contract, the seller accepts the obligation to sell or buy the underlying stock at the strike price. These strategies carry greater risks and must be carefully considered in context to the overall client objectives for the underlying stock.

The collar is created when you add a covered call at a strike price higher than the current market value. A covered call requires the hedger to sell a call option, thereby capping the potential for upside profit while collecting the premium income. This strategy is well suited for a client who recognizes it’s in their best interest to sell, understands the tax consequences, but struggles with the FOMO of potential upside. The downside is protected, and a sale price is defined. Should the stock price rise above the covered call strike price, the stock will be called away; however, should it stay below the covered call strike price through expiration, the client keeps their stock.

A bear put spread is created when you sell a put option at a strike price beneath that of your protective put. Like the collar, the sale of the put generates premium income that offsets the cost of the protective put. In this strategy, however, the client can still benefit from unlimited upside while risking full downside protection. The bear put spread insures loss in value should the stock price fall between the strike prices of the protective put and the short put. Essentially, the hedger is creating a range of protection, believing the stock would never experience catastrophic loss. This strategy could prove useful for a client concerned about an event outcome.

Of course, options are not necessary for every portfolio, but should you identify an insurance need, are you ready to execute on it? Do you understand the risks and how to manage them? Options can be a double-edged sword. The beauty of option contracts is the unlimited scope in which you can combine and implement them; however, it is therefore possible to become frozen in inaction.

As with any insurance product, when you need it most, it will cost you most. Volatility is a factor underlying the costs of options. As volatility spikes and markets crash, the cost of options goes up, further diminishing return when risk is rising.

Therefore, plan ahead and know your options, so your clients can rest easy knowing they’re protected 

Disclaimer: This information does not serve as the receipt of, or as a substitute for, personalized investment advice from Austin Asset or its employees. The opinions expressed are subject to change at any time due to the changes in the market, economic conditions, or tax regulations.

Endnotes

  1. Statistics from the Options Industry Council available at www.optionseducation.org/.
  2. See the Reuters article, “Say Goodbye to the Shortest Bear Market in S&P 500 History,” by Saqib Iqbal Ahmed and Noel Randewich at www.reuters.com/article/us-usa-stocks-s-p500-bear-graphic/say-goodbye-to-the-shortest-bear-market-in-sp-500-history-idUSKCN25E2R9.
  3. See www.businesswire.com/news/home/20170511006089/en/Cerulli-Study-Says-Financial-Advisors-Who-Currently-Use-Options-Expect-to-Increase-Use-of-Options-by-30-Percent-in-Three-Years.