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Know What You Own: Options-Based Hedging Strategies

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Understanding the Diversity of Options Strategies


Options-based strate­gies have seen a lot of recent growth in both assets under man­age­ment and num­ber of prod­ucts avail­able.

Growth in Options Based Funds - Know What You Own Hedging Strategies - Swan Insights

Source: Morn­ingstar Direct


To keep pace with the growth of options-based strate­gies, Morn­ingstar released a new cat­e­go­ry called “Options-Based” to encom­pass those mutu­al funds and ETFs that heav­i­ly use options.


The Morningstar Options-Based Category

Morn­ingstar defines the Options-Based cat­e­go­ry as funds where options are a cen­tral com­po­nent of their invest­ments strate­gies and where trad­ing options may intro­duce “asym­met­ric return prop­er­ties to an equi­ty invest­ment port­fo­lio.” It goes fur­ther to list the vari­ety of strate­gies: “put writ­ing, cov­ered call writ­ing, option spread, options-based hedged-equi­ty, and col­lar strate­gies.”

While the addi­tion of this cat­e­go­ry is cer­tain­ly a step for­ward and a wel­come devel­op­ment, we believe the cat­e­go­ry can be fur­ther divid­ed into dis­tinct sub-cat­e­gories.


Three Subcategories of Options-Based Funds

The poten­tial to mix and match dif­fer­ent option posi­tions and core hold­ings pro­vides an almost lim­it­less range of profit/loss sce­nar­ios, it helps to clas­si­fy option strate­gies into one of three sub-cat­e­gories, name­ly:

  1. Hedg­ing strate­gies
  2. Income strate­gies
  3. Alpha/trading strate­gies

While no clas­si­fi­ca­tion sys­tem is per­fect, most options strate­gies will fall into one of these pri­ma­ry cat­e­gories. But more impor­tant­ly, these cat­e­gories are defined by what the strat­e­gy is try­ing to achieve.

This post will dis­cuss the options-based hedg­ing strat­e­gy with future posts focus­ing on the oth­er two.


Options-Based Hedging Strategies

Hedg­ing strate­gies are defined as hav­ing a core, long port­fo­lio but also tak­ing active steps to hedge down­side mar­ket risk via options. Investo­pe­dia defines a hedge as “an invest­ment to reduce the risk of adverse price move­ments in an asset. Nor­mal­ly, a hedge con­sists of tak­ing an off­set­ting posi­tion in a relat­ed secu­ri­ty.” In our opin­ion, options are an ide­al instru­ment for remov­ing price risk from a port­fo­lio.

It is impor­tant to note that many strate­gies include the term “hedge” in their name but might not be direct­ly reduc­ing mar­ket risk. For this sub­clas­si­fi­ca­tion, we are lim­it­ing our def­i­n­i­tion of hedg­ing strate­gies to those that explic­it­ly seek to off­set mar­ket risk.


Variations within the Category

With­in this cat­e­go­ry, there may be vari­abil­i­ty since there are many ways to imple­ment a hedg­ing strat­e­gy. Some ele­ments that can affect each strat­e­gy are:

  • the inclu­sion of addi­tion­al trades to off­set the hedg­ing cost
  • where the lev­els of hedge pro­tec­tion are set
  • the amount spent on hedg­ing
  • time to expi­ra­tion of the hedges used
  • if the strat­e­gy is always hedged or on a “risk-on/risk-off” approach

These vari­ables will undoubt­ed­ly lead to a dis­per­sion of results with­in the sub-cat­e­go­ry. For exam­ple, of the 38% that could be quan­ti­fied as hedged equi­ty (24 funds), only six funds appear to uti­lize puts expir­ing between 120 days and 365 days out, while four funds (all Swan) use puts expir­ing greater than 365 days out. Four­teen funds uti­lize short­er-term hedg­ing of less than 120 days and six funds use put spreads to hedge (lim­it­ed pro­tec­tion).

The time to expi­ra­tion and type of hedge will have a great impact on how each of these funds will per­form dur­ing a bear mar­ket. If the bear mar­ket extends beyond 120 days, most could run into a very cost pro­hib­i­tive hedg­ing envi­ron­ment.


When It Works

Hedg­ing strate­gies do best when mar­kets sell off. After all, that is what hedg­ing is designed to do. Gen­er­al­ly speak­ing, the big­ger the sell-off, the more valu­able the hedges become. Giv­en the fact that cor­re­la­tions tend to spike across most asset class­es and strate­gies dur­ing a true mar­ket rout, direct, explic­it hedg­ing is one of the best ways to off­set mar­ket risk.


Possible Risks and Drawbacks

Lag in an Upward Market

The draw­back to a hedg­ing strat­e­gy is that it will like­ly lag in an upward mar­ket. If the hedge is expect­ed to rise in val­ue if the mar­ket falls, then it stands to rea­son the hedge should fall in val­ue if the mar­ket ris­es. This can cause investors to view the hedge as a “cost” dur­ing upward mar­kets.

Price Paid for the Hedge

Anoth­er risk to hedg­ing strate­gies is the price paid for the hedge. The price of hedg­ing is dri­ven by sup­ply and demand. Dur­ing times of com­pla­cen­cy, hedg­ing can be cheap. How­ev­er, when mar­kets start sell­ing off and investors pan­ic, the price of hedg­ing can sky­rock­et. A good hedg­ing strat­e­gy should antic­i­pate the price of hedg­ing will increase when hedg­ing is most need­ed and have a plan to accom­mo­date that out­come.

Counterparty Risk

If one owns a hedge that is designed to pay off hand­some­ly if the val­ue of an asset falls, one should be sure that the coun­ter­par­ty in the agree­ment is in a posi­tion to pay. This risk was real­ized dur­ing the Glob­al Finan­cial Cri­sis, when some hedges were endan­gered by the counterparty’s inabil­i­ty to meet their con­trac­tu­al oblig­a­tions. Since the GFC, there has been a big push for hedg­ing and deriv­a­tive con­tracts to move to exchanges where the terms are stan­dard­ized, and the back­ing is pro­vid­ed by clear­ing­hous­es.


Finding the Strategy that Fits

Options-based strate­gies can be quite diverse and one of the best ways to make sense of them is to iden­ti­fy their objec­tives, ben­e­fits, and risks. Each strat­e­gy has dif­fer­ent objec­tives and risk/return char­ac­ter­is­tics and under­stand­ing this will help advi­sors and investors make bet­ter informed deci­sions about which strate­gies to include in their finan­cial plans.

In the next two posts, I will dive deep­er into income strate­gies and alpha/trading strate­gies.


About the Author

Marc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Portfolio Manager - Swan Global InvestmentsMarc Odo, CFA®, CAIA®, CIPM®, CFP®, Client Port­fo­lio Man­ag­er, is respon­si­ble for help­ing clients and prospects gain a detailed under­stand­ing of Swan’s Defined Risk Strat­e­gy, includ­ing how it fits into an over­all invest­ment strat­e­gy. For­mer­ly, Marc was the Direc­tor of Research at Zephyr Asso­ciates for 11 years.



Important Notes and Disclosures

Swan Glob­al Invest­ments, LLC is a SEC reg­is­tered Invest­ment Advi­sor that spe­cial­izes in man­ag­ing mon­ey using the pro­pri­etary Defined Risk Strat­e­gy (“DRS”). SEC reg­is­tra­tion does not denote any spe­cial train­ing or qual­i­fi­ca­tion con­ferred by the SEC. Swan offers and man­ages the DRS for investors includ­ing indi­vid­u­als, insti­tu­tions and oth­er invest­ment advi­sor firms. Any his­tor­i­cal num­bers, awards and recog­ni­tions pre­sent­ed are based on the per­for­mance of a (GIPS®) com­pos­ite, Swan’s DRS Select Com­pos­ite, which includes non-qual­i­fied dis­cre­tionary accounts invest­ed in since incep­tion, July 1997, and are net of fees and expens­es. Swan claims com­pli­ance with the Glob­al Invest­ment Per­for­mance Stan­dards (GIPS®).

All Swan prod­ucts uti­lize the Defined Risk Strat­e­gy (“DRS”), but may vary by asset class, reg­u­la­to­ry offer­ing type, etc. Accord­ing­ly, all Swan DRS prod­uct offer­ings will have dif­fer­ent per­for­mance results due to offer­ing dif­fer­ences and com­par­ing results among the Swan prod­ucts and com­pos­ites may be of lim­it­ed use. All data used here­in; includ­ing the sta­tis­ti­cal infor­ma­tion, ver­i­fi­ca­tion and per­for­mance reports are avail­able upon request. The S&P 500 Index is a mar­ket cap weight­ed index of 500 wide­ly held stocks often used as a proxy for the over­all U.S. equi­ty mar­ket. Index­es are unman­aged and have no fees or expens­es. An invest­ment can­not be made direct­ly in an index. Swan’s invest­ments may con­sist of secu­ri­ties which vary sig­nif­i­cant­ly from those in the bench­mark index­es list­ed above and per­for­mance cal­cu­la­tion meth­ods may not be entire­ly com­pa­ra­ble. Accord­ing­ly, com­par­ing results shown to those of such index­es may be of lim­it­ed use. The adviser’s depen­dence on its DRS process and judg­ments about the attrac­tive­ness, val­ue and poten­tial appre­ci­a­tion of par­tic­u­lar ETFs and options in which the advis­er invests or writes may prove to be incor­rect and may not pro­duce the desired results. There is no guar­an­tee any invest­ment or the DRS will meet its objec­tives. All invest­ments involve the risk of poten­tial invest­ment loss­es as well as the poten­tial for invest­ment gains. Pri­or per­for­mance is not a guar­an­tee of future results and there can be no assur­ance, and investors should not assume, that future per­for­mance will be com­pa­ra­ble to past per­for­mance. All invest­ment strate­gies have the poten­tial for prof­it or loss. Fur­ther infor­ma­tion is avail­able upon request by con­tact­ing the com­pa­ny direct­ly at 970–382-8901 or  440-SGI-110118

By |2018-11-15T16:02:24+00:00November 1st, 2018|Blog|Comments Off on Know What You Own: Options-Based Hedging Strategies