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August 14, 2012  Tue 9:02 AM CT

Recently we discussed the high cost of constant hedging through the use of protective puts and collars. But if those strategies aren't the best way to consistently hedge the markets, then what are?

First, let's acknowledge that this is the $64,000 (or $64 million) question. Hedge funds get paid the big bucks to figure out exactly those issues, and there are billions of dollars in "tail risk" or "black swan" funds that are supposed to have some answers. But most managers of those funds admit that they will lose a fair amount in bullish or neutral years.

Some traders look to the VIX exchange-traded funds to hedge, but we have already discussed the shortcomings of the VIX options and funds extensively. (The basic problem is that they are all based on the VIX futures, which almost always carry premium to the spot volatility index). I do believe that long volatility is the answer, but it's clearly not a simple proposition.

The best hedging requires tactical trading. It requires a concerted effort to find the best hedges at the appropriate times and levels.

When implied volatilities are low, then outright put buying makes sense. That could be in a fund like the SPY or its underlying stocks, depending on which has lower relative implied volatilities. It could also mean looking at VIX options or those of the iPath S&P 500 VIX Short-Term Futures exchange-traded note (VXX). Or it could be options in the iShares Barclays 20+ Year Treasury Bond Fund (TLT), as bonds have a high inverse relationship with equities.

Best hedging practices could still include collars if the underlying has risen up to resistance, or diagonal collars as I often like to use if the volatility data warrants it. When the implied volatility is high, vertical spreads or calendar spreads might make the most sense. Backspreads might be appealing and appropriate for most advanced options traders.

I know everyone wants an easy answer, but there isn't one. We retail traders are up against the best and the brightest in the market. They spent all of their time, financial resources, and Ph.D brains trying to figure these things out, and the simple answers have been exploited long ago.

Nevertheless, there are some basic rules to consider. The first is to determine the level of the hedge needed. I use volatility levels and moving averages to decide how much of a hedge I want.

Then I search for the best-priced hedge. That means spending a lot of time looking at relative volatility levels. If volatility is very low, then long puts are the way to go. You should look to buy them as far out in time as you can with that low volatility.

Unfortunately it will likely be higher the farther out you go as the mean reversion is usually already priced in. When volatility is high, go for spreads, collars, or combinations of both.

The situation is easier if you aren't obligated to own stock. Option traders can choose from a variety of calls, puts, and vertical spreads in either direction. Volatility levels and moving averages can be used to determine the amount of exposure.

For example, when markets are selling off and volatility is high, one can load up on put spreads to balance call spreads held. And when markets are bullish and volatility is low, some outright puts can be a nice addition to long call spreads.

(A version of this article appeared in optionMONSTER's What's the Trade? newsletter of July 25.)
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