How To Hedge Your Stock Portfolio
Learn how to use covered calls to reduce the price of buying a call or to hedge for the downside potential of your existing stocks.
Bullish Option | Diagonal Spread
Hedging Strategies for the Stock Market
Learn how to set up and profit from diagonal calendar spreads
How to hedge your portfolio
Hedging is a strategy designed to reduce the risk of adverse price movements for a given asset. For example, if you wanted to hedge a long stock position you could purchase a put option or establish a collar on that stock.
Both of these strategies can be effective when dealing with a single stock position, but what if you’re trying to reduce the risk of an entire portfolio? A well-diversified portfolio generally consists of multiple asset classes with many positions. Employing either of the techniques above on every equity position in a portfolio is likely to be cost prohibitive.
Another alternative would be to liquidate part of your equity holdings, which could partially offset the impact of a stock market decline. Most long-term investors, however, aren’t comfortable moving in and out of stock positions, either because of the potential tax consequences or because they want to avoid having to time their re-entry.
What other alternatives are available for investors interested in hedging a portfolio? Here, we’ll look at a cost-effective method for hedging an entire portfolio using S&P 500® Index ($SPX) put options.
Hedging isn’t for everyone
Portfolio hedging is considered an intermediate to advanced topic, so investors considering this strategy should have experience using options and should be familiar with the trade-offs they involve. Many investors have a long-term horizon and try to ignore short-term market fluctuations. However, hedging may make sense for tactical investors with shorter-term horizons, or those who have a strong conviction that a significant market correction might occur in the not-too-distant future. A portfolio hedging strategy is designed to reduce the impact of such a correction, in the event that one occurs.
How do I select a hedge?
Effectiveness and cost are the two most important considerations when setting up a hedge.
A hedge is considered effective if the value of the asset is largely preserved when it is exposed to adverse price movements. Here, we’re trying to hedge the equity portion of our portfolio against a market sell-off. Therefore, the hedge should appreciate in value enough to offset the depreciation in portfolio value during the market decline. Ideally, the hedge would preserve the value of the portfolio regardless of the severity of the sell-off.
How much would you be willing to pay to hedge your entire portfolio for a certain period of time? Perhaps the answer depends on your belief in the likelihood of a significant market correction. For example, if you strongly believe that the stock market will decline anywhere from 5–8% over the next three months, an effective hedging strategy that costs less than 5% may be worth consideration.
If you have a well-diversified equity portfolio, S&P 500 ($SPX) put options might be a good choice. In addition, options on the S&P 500 Index are considered “1256 contracts” under tax law and offer the following benefits:
Favorable tax treatment: Many broad-based index options qualify for a 60% long-term/40% short-term capital gains treatment. Other broad-based index options that qualify include those that overlay the Dow Jones Industrial Average ($DJI), Russell 2000 Index ($RUT), and Nasdaq 100 ($NDX).
Cash settlement: All index options are cash settled, which makes the position easier to manage around expiration.
Leverage: $SPX put options have a 100 multiplier which provides the potential to offset a substantial decline in the portfolio for a relatively small upfront cost.1
In order to establish a true hedge on an individual portfolio it may be difficult, if not impossible, to find a single financial product that’s perfectly correlated to your portfolio. In the following example, we assume the equity portion of the portfolio has a constant 1.0 beta to the S&P 500 index. Of course, correlation will vary among individual portfolios.
Now let’s see how you might put a hedge to work.
Portfolio hedge in action
You own a $1,000,000 portfolio with high equity concentration. The equity portion of the portfolio is well-diversified and is closely correlated to the S&P 500 (meaning the beta is ~ 1.0), but the beta of your overall portfolio is 0.80 to take into account the other assets in your portfolio, such as fixed income. This implies that when the value of the S&P 500 index declines 1%, the value of your overall portfolio will decline by 0.80% (assume the non-equity portion of your portfolio remains unchanged and the 0.80 portfolio beta remains constant throughout this example).
You are concerned that the S&P 500 may sell off substantially over the next three months.
You are willing to spend 3% of the total portfolio value (or $30,000) to hedge your portfolio for three months.
The SPX is currently at 1407 and the VIX (the average implied volatility of SPX options) is currently at 17.
The cost of one SPX 1405 put option that expires in three months is $5,000 ($50 ask price).
For this example, we are using the at-the-money strike price to obtain immediate downside protection in the event of a sell-off. The 3% or $30,000 allocated for this hedging strategy is used to purchase a total of six SPX 1405-strike put options:
$50.00 (ask) x 6 (# of contracts) x 100 (option multiplier) = $30,000 (excluding commissions)
The table below illustrates how the value of the portfolio would be affected based on the performance of the SPX at the expiration of the three month SPX put options.
SPX percentage change Portfolio percentage change SPX value Value of six SPX 1405 puts Portfolio value Portfolio value with SPX puts Hedged portfolio percentage change
+5% +4% 1477.35 0 $1,008,800 $1,008,800 +0.88%
0% 0% 1407.00 0 $970,000 $970,000 -3.00%
-5% -4% 1336.65 $41,010 $931,200 $972,210 -2.78%
-10% -8% 1266.30 $83,220 $892,400 $975,620 -2.44%
-15% -12% 1195.95 $125,430 $853,600 $979,030 -2.10%
-20% -16% 1125.60 $167,640 $814,800 $982,440 -1.76%
Source: Schwab Center for Financial Research. There is no change in the value of the other assets in the portfolio. Data represents value at expiration.
Let’s walk through the calculations for the instance in which the S&P declines 5% (highlighted in blue in the table):
Portfolio percentage change = -4%. This figure takes into account the 0.80 beta of the portfolio (5% x 0.80 = 4%).
SPX value=1336.65. This is a 5% decline from the initial value (1407 x 0.95).
Value of six SPX 1405 puts = $41,010. This is the value of the puts at expiration (1405-1336.65 x 6 x 100).
Portfolio value = $931,200. This is a 4% decline (when taking 0.80 beta into consideration) from the initial portfolio value of $970,000 (taking the cost of the hedge into consideration) ($970,000 x 0.96).
Portfolio value with SPX puts = $972,210. This is the value of 6 SPX 1405 puts plus the equity portfolio value ($41,010 + $931,200).
Hedged portfolio percentage change = -2.78%. This represents the percent change of the total portfolio from the initial $1,000,000 value ($1,000,000 – $972,210 = $27,790/1,000,000).
As you can see, this hedging strategy was highly effective, as the value of the portfolio was preserved in all scenarios. The portfolio never lost more than the 3% that we allocated for the cost of the hedge.
How did I choose the hedge amount?
It’s important to understand that I didn’t arbitrarily choose a hedge that accounts for 3% of the portfolio value. After conducting some research, I determined that the 3% cost represented the minimum amount that could be spent in order to preserve the value of the portfolio less the cost of the hedge (based on the assumptions listed above). For example, if I had allocated just 1% of the portfolio value and the SPX had declined 0–20%, the portfolio value would have declined 1–15%. So, 1% simply doesn’t provide an adequate hedge.
How does the VIX affect the hedge?
At the time that I obtained the $50 ask price on the SPX put options, the VIX was at 17. The VIX represents the average implied volatility of SPX options. If the VIX is higher than 17, the three-month at-the-money options will be more expensive and an equivalent hedging strategy would cost you more than 3%. Of course, if the VIX is below 17 you could establish an equivalent hedge for less than 3%.
What if cost is a concern?
If you feel that 3% of the total value of your portfolio is simply too much to spend on a hedging strategy, you may want to consider selling covered calls on some of the individual equity positions in your portfolio to help offset the cost. Because we purchased puts on an index that we do not own, we can’t sell calls on that index without establishing a naked call position. If you are not comfortable with selling calls on your stocks and you are still concerned with the cost, then this strategy may not be appropriate for you.
Is it worth it?
The hedging strategy presented above provides an efficient way to hedge an entire portfolio, but is the cost worth the benefit? Some investors may take comfort in knowing that the “worst-case scenario” for their portfolio is being down 3% for the next three months. Others may feel that establishing a short-term hedge is equivalent to timing the market and may therefore elect to focus on the long-term. Regardless of your opinion, gauging the likelihood of a significant market decline may be helpful.
One way to obtain an approximate likelihood of various SPX price levels is to look at the Delta of the put strike prices that corresponded to the percentage decline levels. The table below shows that at the time our sample hedge was established, the probability that the SPX would drop 5% or more in three months was roughly 27%.
Likelihood of SPX Falling
SPX change 0% -5% -10% -15% -20%
Strike price 1405 1335 1265 1195 1125
Delta of strike 0.45 0.27 0.14 0.07 0.04
Percentage chance that the SPX closes below the strike 45% 27% 14% 7% 4%
Source: Schwab Center for Financial Research.
Of course, the more severe declines are accompanied by lower probabilities, but this type of information may help you determine whether the cost of hedging a portfolio is worth it or whether you should ride it out.
The two most important reasons for setting up a covered call:
- Reduce cost basis of buying a stock
- Hedge an existing stock portfolio if you already own 100 shares of a stock.
- Covered calls are profitable even if the stock down’t move
A covered call reduces the cost basis of buying a stock by accepting a premium for selling a put above the stock price.
If you were to sell the 105 put for a premium of 5 dollars. The collected premium effectively lowers the cost basis of buying 100 shares of the stock at 100 dollars to buying the 100 dollars of shares at 95 dollars. The break even price is now 95 dollars.
A bullish long call diagonal spread is set up by
- Buy a distant month ITM call at a lower strike price
- Sell a proximate month OTM call at a higher strike price
- total debit paid should be no more than 75% of the strike width
- The intrinsic value of the long strike should approximate the short strike.
You will want to set this trade up in a low volatility environment but with a bullish direction.
A Long Call Diagonal Spread is constructed by purchasing a call far out in time, and selling a near term call on a further OTM strike to reduce cost basis. This trade is set up as a debit.
This option is typically closed when the short option expires. However, it is also common close the short option only to sell another short option for more premium either at the same strike price.
The setup of a diagonal spread is very important. If we have a bad setup, we can actually set ourselves up to lose money if the trade moves in our direction too fast.
To ensure we have a good setup, we check the extrinsic value of our longer dated ITM option. Once we figure that value, we ensure that the near term option we sell is equal to or greater than that amount.
The deeper ITM our long option is, the easier this setup is to obtain. We also ensure that the total debit paid is not more than 75% of the width of the strikes.
We never route diagonal spreads in volatility instruments. Each expiration acts as its own underlying, so our max loss is not defined.
The best stock movement scenario = ( believe it or not ) is for the stock to move in your favor and blow by above your short strike.
The short strike would lose all of its value, but this is offset by the profit of the ITM in the money long options. You would collect the maximum profit of the ( strike width + the premium received ) or 10+5 = 15.
You would only manage a covered call if the stock price completely goes against you and is below the break even price.
Recall that a covered is profitable if either the stock price stays the same, moves between the strikes, or even it it moves above the short strike ( this is actually the best scenario )
Buying a Call
Profit and Loss Chart
- Max Profit Potential: (Short Call Strike + Credit Received for Call – Share Purchase Price) x 100
- Max Loss Potential: (Share Purchase Price – Credit Received for Call) x 100
- Expiration Breakeven: Share Purchase Price – Credit Received for Call
- Approximate Probability of Profit: Greater than 50%
Buying a Call
As you can see, buying 100 shares of stock at $75 and selling the 80 call for $3 reduces the risk of the position compared to just buying and holding stock. Since a credit is collected for selling the call, the purchase price of the shares is effectively reduced by the amount of the call price. Therefore, the breakeven price of a covered call position is essentially the reduced purchase price of the shares. However, for this purchase price reduction, the position’s potential profits are capped when the stock price rises above the strike price of the short call.
You know the potential outcomes of a covered call position at expiration, but what about before expiration? As a demonstration, we’re going to look at a few positions that recently traded in the market.As you can see, buying 100 shares of stock at $75 and selling the 80 call for $3 reduces the risk of the position compared to just buying and holding stock. Since a credit is collected for selling the call, the purchase price of the shares is effectively reduced by the amount of the call price. Therefore, the breakeven price of a covered call position is essentially the reduced purchase price of the shares. However, for this purchase price reduction, the position’s potential profits are capped when the stock price rises above the strike price of the short call.
We’ve also added the profits and losses for a long stock position as a comparison. Compared to the long stock position, the covered call has less loss potential and more profit potential at most of the prices. However, if the stock price rises significantly above the short call strike, then the long stock position without a short call against it performs better. Because of this, a covered call writer is usually not extremely bullish on the stock.
Buying a Call
Covered Call vs Holding Shares
Income Generation Using Covered Calls
Buying a Call
A Defensive Covered Call
Covered call writing provides protection against declines in the stock price. Because of this, covered calls can be used defensively. So, in the final example, we’ll look at a scenario where a covered call position is unprofitable but better off than just buying and holding stock.
Here are the specifics of the final example:
- Initial Share Purchase Price: $119.99
- Strikes and Expiration: Short 120 call expiring in 37 days
- 120 Call Sale Price: $2.58
- Breakeven Stock Price (Effective Share Purchase Price):
- $119.99 share purchase price – $2.58 credit received from call = $117.41
- Maximum Profit Potential:
- ($120 short call strike – $117.41 effective share purchase price) x 100 = $259
- Maximum Loss Potential:
- $117.41 effective share purchase price x 100 = $11,741 (stock price goes to $0)
Covered call example trade.
In this particular trade, the stock price fell sharply, resulting in losses for the covered call writer and the long stock investor. However, since the covered call writer collected $2.58 in premium, their loss was $258 less than the long stock investor at the expiration of the short call, demonstrating how a covered call can be used defensively.
Buying a Call
How To Choose the Strike Prices for a Covered Call
In order to better understand how the covered call strategy has performed over time, tastytrade designed and conducted a study that segmented the results by call delta.
Delta is, of course, the Greek that tells us how much an option’s price will change for every $1 move in the underlying. So at-the-money options, which are more sensitive to underlying price movement, have higher deltas, while out-of-the-money (OTM) options have lower deltas.
In terms of strike selection, that means that traders selling ATM covered calls would be selling approximately 50 delta calls. From there, going higher on the strike ladder (further out-of-the-money), reduces the delta.
In the study, tastytrade analyzed 50 delta, 30 delta, 16 delta, and 5 delta covered calls to provide a snapshot of the relative performance of covered calls across the delta spectrum. The study used data from 2005 to present and evaluated options with an average duration of 45 days-to-expiration.
The graphic below highlights the results of this study:
As you can see from the above, the data indicates several important trends.
First, the ATM covered call strategy does not produce as high returns as the other delta levels (on average). Additionally, the 50 delta strategy also missed out on profits the highest percentage of the time (43.96%).
On the other hand, the 16 delta strategy returned the highest average P/L, while missing out on profits only 14.88% of the time.
The results above obviously take into account a broad range of market conditions. Therefore, traders with no opinion on the direction of the markets may lean toward selling lower delta covered calls, such as the 16 delta category illustrated in the graphic above.
However, it’s certainly possible that traders may also align their covered call strategy with their view on market direction, which may call for a different choice in strike selection. Obviously, in bear markets, the relative performance of higher delta covered calls will improve.At this point, you know how covered calls work, as well as when you might use the strategy. However, with so many different call strikes available, how do you choose which one to sell? We’ve put together a simple guide that may help the strike price selection process easier.
Strike Price Selection: Determine Your Stock Price Outlook
Before selecting a call strike to sell, it’s crucial to determine an outlook for the shares of stock that you own. Here is a quick guide that demonstrates how to select a call strike based on various outlooks:
You Believe the Share Price Will Increase Significantly:
With such a bullish outlook, selling calls to limit the profit potential on the long shares might not make sense. Additionally, selling far-out-of-the-money calls doesn’t provide much profit potential or downside protection since far-out-of-the-money options are cheap.
You Believe the Share Price Will Increase Moderately:
Selling a call option with a delta between 0.20 – 0.30 may be logical, as those options only have a 20-30% probability of being in-the-money at expiration (in theory).
You Believe the Share Price Will Remain Flat/Decrease Slightly:
With a neutral outlook, selling calls with strike prices closer to the stock price (.40 to .50 delta calls) may be logical. Selling at-the-money calls provides the greatest profit potential from the decay of the call’s extrinsic value.
You Believe the Share Price Will Fall:
With such a bearish outlook, owning shares of stock or trading covered calls is likely not the appropriate strategy.
The table above serves as a guideline for selecting a call to sell. When trading covered calls, there isn’t a “one-size-fits-all” approach. The call that is sold depends on the investor’s outlook for the stock price in the future.
Awesome! You’ve reached the end of the guide. Hopefully, you’re much more confident in your understanding of the covered call options strategy.
How Do Covered Calls Change with Volatility and Time
A call option will benefit from :
- A rise in stock prices
- A rise in volatility
- An early rise in stock price ( time kills the stock value )
- Positive Delta – Call prices rise when the stock price increases, which benefits the call buyer. Conversely, call prices fall when the stock price decreases, which is not good for the call buyer.
- Positive Gamma – A long call’s position delta gets closer to +100 as the stock price increases and closer to 0 as the stock price decreases.
- Negative Theta – The extrinsic value of options decays as time passes, which is detrimental to a call buyer
- Positive Vega – An increase in volatility will increase the value of a call option ( indicated by positive vega ). Conversely, a decrease in volatility will decrease the value of a call option ( indicated by a negative vega
Buying a Call
Management and Adjustments
- Maximum Profit Potential: Unlimited
- Maximum Loss Potential: Premium Paid for the Call
- Expiration Breakeven Price: Call Strike + Premium Paid for Call
- Estimated Probability of Profit: Less Than 50%
- Assignment Risk?
Tips and Tricks
A call option will benefit from :
- A rise in stock prices
- A rise in volatility
- An early rise in stock price ( time kills the stock value )
Buying ITM -in the money call options will
- Increase the amount of directional exposure since in the money options have deltas closer to +1
- ITM options are less affected by theta decay
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