Education Newsletter

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 or collars reduce volatility 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.

I hate to break it to the doom mongers out there, but the country is simply not going into recession. Yes, there are plenty of things to be worried about, but these are long-term societal and institutional problems.

Basically, Americans and Europeans are working less. Thanks to a combination of the welfare state, poor education, and bad parenting, our nation has developed a large class of unfortunate people who are well into their 20s--if not older--but have never been productively employed. They fill our prisons and wander around colleges in a perpetual students. Many work for the government.

Unfortunately, most of these people are destined not to enjoy rising incomes in their lifetimes. Nor are they likely to start small businesses and hire others. Somewhere among their ranks is the next Larry Page or Steve Jobs or Bill Gates, but too few will reach that potential. We'll all be poorer as a result.

I believe that this social condition--a large group of marginalized people--is what's really weighing on the economy now. They require government spending and don't contribute to income growth or job creation.

This situation lies at the heart of the European debt crisis and ultimately explains why the United States lost its AAA rating over the summer. It's also the reason that non-farm payrolls have not posted bigger gains.

This problem is long-term and secular and nature, but it has been misdiagnosed as a cyclical downturn. That's why the negativity is failing to spread and why, in the last eight days, we've seen improving small-business confidence, strong retail-sales data, rising industrial production, and a surprising pop in homebuilder confidence. (I actually suspect that it's finally time to think about returning to that beaten-down sector.)

The good news is that there is no recession. Stocks remain under-owned.

Granted, there are headwinds. In additional to the social problems mentioned above, companies now face real inflationary pressures. Just ask Coca-Cola, Steel Dynamics, ConAgra, and Mattel, to name a few. They're also encountering a novel problem of weak government demand, with IBM and Badger Meter some recent examples on that front.

But there are just as many positives, many of which I have cited in earlier columns: The United States is turning back to primary industries such as mining, agriculture, and energy after decades of slumber. One particular name exposed to that trend is Terex, which makes the giant trucks used in mines. Its last earnings report on July 20 missed forecasts because of supplier constraints, and the stock took a severe beating.

Still, orders and revenue remained strong, and we saw some call buying in Terex ahead of its next earnings report on the morning of Oct. 27 we saw some call buying today. The stock is breaking above its 50-day moving average and might be an interesting name to consider around current levels.

Another is heavy-machinery company CNH Global, which reports at the same time. It also had very strong results last quarter but has gotten knocked down along with the rest of the market.