In the stock market, insurance is essentially purchasing a put option. For the put option buyer, from an insurance perspective, the only significant drawback is the high cost, but aside from that, puts offer many advantages. However, to make the most of put options as a hedge, it’s essential to understand the associated risks and strategies.
The Risks in Options: Theta, Delta, and Vega
When we discuss options, especially puts, we mention three key risk factors, known as the Greeks: Theta, Delta, and Vega. These risks don’t all appear simultaneously or move in the same direction. Specifically, a long put option will typically experience:
- Negative Theta: As time passes, the value of the option decreases.
- Negative Delta: If the stock market falls, the put’s value rises, but if the market rises, the put value decreases.
- Positive Vega: As volatility increases, the value of the put also rises.
These risks can be managed, but understanding how they interact is crucial for using options effectively.
The Risks of Buying a Put
For put buyers holding a market position, the biggest risk is time decay. If the stock price doesn’t drop to the strike price by expiration, the put option will expire worthless. This is a common characteristic of all insurance policies, and while it may seem like a disadvantage, it’s not inherently negative.
A put option also carries Delta risk—if the market rises, the value of the put decreases. However, when used for insurance purposes, this risk becomes less significant. For example, if you hold one share of SPY and one out-of-the-money (OTM) SPY put, the Delta of the put is much smaller than 1. When the market rises, the losses from the put are offset by the increase in the stock price, making the overall portfolio value increase.
Finally, as volatility increases, the value of the put will benefit from both an increase in the VIX and a decline in SPX. A rational, responsible fund manager holding large stock positions should always have a reasonable amount of puts in place to hedge at appropriate prices.
The Cost of Buying Put Options
However, the cost of puts is quite high. Typically, an at-the-money (ATM) put option with a one-month expiration could cost about 2% of the SPX, with an annualized cost of up to 20%, depending on the level of VIX. For any individual or fund manager, using puts in this way to hedge against risk would consume most of the expected profits. The cost of hedging should generally not exceed 5% of the account value.
Two Popular Strategies to Reduce Hedging Costs
To reduce the cost of hedging, investors often use two common strategies: Bear Put Spread and Put Butterfly. These strategies allow for lower premiums compared to simply buying a put option.
1. Bear Put Spread: Lower Cost with Limited Risk
A Bear Put Spread strategy involves buying a higher strike near-ATM put and selling a lower strike OTM put with the same expiration. For example, when SPY was at 610 points, you could buy a SPY 1X570P – 1X540P spread. When VIX is low, this spread can be inexpensive—costing only around 30-50 points.
In terms of Greek letter risks, the Bear Put Spread behaves similarly to a simple put but with smaller Theta and Delta risks and larger Vega risk. Overall, this strategy provides a low-cost, low-risk form of insurance.
2. Put Butterfly Spread: Lower Premiums with More Complexity
The Put Butterfly strategy involves buying one SPY 1X570P, selling two SPY 1X540P, and buying one SPY 1X510P. This strategy allows for lower premiums compared to the Bear Put Spread under similar VIX conditions but introduces more complexity and risk.
The key advantage of the Put Butterfly strategy is that even when VIX is high and options are more expensive, it can still be purchased at a relatively reasonable price. The profit curve for this strategy may look like this:
- Even when the market is experiencing volatility, this strategy is still relatively affordable.
- However, its risk is more complex. Vega risk is negative, meaning if volatility spikes rapidly, the value of the option could fall sharply.
The Benefits and Risks of the Put Butterfly
One critical feature of the Put Butterfly is that it allows you to hedge against volatility more effectively. If volatility spikes without a corresponding drop in the stock price, the Delta and Vega characteristics of the option might offset each other, leading to paper losses.
But why is this still useful?
Because stock prices don’t usually fall from 570 to 520 overnight. While this might seem like a short period on a profit curve, even fast adjustments in the stock market could take over 20 days. During that time, profits would slowly rise, and if expiration is nearing, the 540 and 510 segments might become worthless, replicating the insurance-like effect of the previous strategies.
Even with more time before expiration, this option strategy will slowly appreciate in value, although more gradually than other strategies. The real advantage here is that the cost of this strategy is much lower, so you can purchase more contracts for the same cost and still achieve a similar insurance effect.
A Unique Aspect: Theta and Vega Behavior
A significant difference between the Put Butterfly and the previous two strategies is the behavior of the Greek risks. The Put Butterfly has a variable Theta, which can be positive, negative, or neutral depending on the specific structure of the spread.
- While it remains negative Delta (to hedge against a market decline), the Vega is almost always negative, which is a stark contrast to the other strategies.
This means the value of the option could depreciate quickly if volatility increases drastically, even if the stock price doesn’t decline. This is a risk that investors should be aware of—especially when volatility rises without a corresponding drop in the stock market.
Conclusion: The Importance of Understanding Options
For individuals using options as part of their portfolio management, it’s critical to understand the risks involved and choose strategies that either have zero risk (other than the premium paid) or limited risk. The biggest enemy in options trading is often volatility, which is why the VIX should always be closely monitored.
In essence, options engineering is about designing the right option strategies for specific goals, and this requires a deep understanding of Theta, Delta, and Vega risks. If you’re an investor or fund manager, remember that making the right choice in option strategies can significantly impact your portfolio’s performance.
Finally, always remember: when engaging in options trading, you must understand the risks and have the right risk management in place. If you’re unsure, always use tools to assess risk (like IB’s options analysis tools) to make informed decisions.
Note: This post includes general advice and examples of option strategies, and should not be considered as investment advice. Always consult a financial advisor before making investment decisions.