I have been looking at various ways of hedging equity exposure while reducing costs with the VIX at elevated levels. Simple strategies are too expensive, especially when the volatility index is above 30. But high volatility also means that hedging is even more important.
There is considerable debate about the costs of hedging and while there are ever more "tail risk" funds
out there, many traders have come to the conclusion that hedging simply isn't worthwhile. Most of these folks are basing their analysis--or lack thereof--on the idea of simple and static strategies such as buying SPX puts or VIX calls.
A quick look at the returns of the CBOE PutWrite Index
, however, shows that traders are better off selling puts than buying them. Slightly more complex strategies such as put spreads
and the costs of outright puts. But they do have limitations.
Put spreads limit gains on the downside and therefore provide limited protection. Collars limit the upside and will not keep up with index performance in strong bull markets. An interesting alternative to the collar brings more option dynamics into play.
Many hedgers buy long-term puts to limit time decay
. And option sellers usually like to sell the near term for the same reason, as time decay is greatest as expiration approaches. So the alternative collar buys the longer-term puts and sells the nearer-term calls. A study was done on one form of this strategy using the PowerShares QQQ Trust and can be found here
The strategy has shown significantly higher returns over the test period. From April 1999 to September 2010, the QQQ had an annualized return of -0.39, while the alternative collar had a return of 9.56 percent. And that was one with just one third the volatility.
Those who have followed my recent Options Academy
webinars know that the diagonal collar can be done without the long stock to reduce the margin by a huge amount. One simply buys long-term calls and sells the near-term contracts against them, creating the exact same risk profile.
A regular diagonal spread is a range-bound trade that has risks if the stock moves too far in either direction, but this construction offers a number of advantages.
Taking the strategy one step further, one can use the Weekly options against the Monthly. Because the Weeklies are relatively new, we can't backtest this strategy too far, but results have been promising.
It uses the rapid time decay of the Weekly options while having long vega
. Vega comes into play when equities sell off, and while the strategy profits in a given range, increased volatility can boost those gains.
For instance, I recently established the following spread: long the SPY November 119 calls and short the Weekly 122 calls. This would be virtually identical to being long the SPY, long the November 119 puts, and short the Weekly 122 calls. I like the spread because I believe that the resistance at 122 is holding well, but I still have a positive delta
I also have a large positive theta
, meaning that I will profit from the time decay of those Weekly calls. And I have a positive vega
. I will roll the short calls out tomorrow as the new Weeklies come up.
Of course, there are limitations and tradeoffs to every hedging strategy. Many option traders find that when they are running such strategies there is no need to own the stock, as they can replicate the position using only options with much lower margin.
The diagonal collar offers a great improvement over long stock under most circumstances and could be one alternative.