Stock Option Investment Advice

Stock Insurance OR Portfolio Insurance – Revisited

With the addition of new and interesting securities to help hedge a stock portfolio, the question arises more and more: ‘Is it better to insure my stock directly or use a different hedge to insure my portfolio?’

This is a very important question which has many components to it. During a PowerOptions Open Forum Webinar on January 14th, 2014 this question was posed. The actual question was:

  1. “I am looking to purchase shares of General Electric (GE) at a cost of about $26.75. If I am concerned about a pull back or decline in the short term, is it best to:
  2. Insure the stock directly with a married put position?
    Insure the position by purchasing a put option on the S&P 500 Index ($SPX) or the ETF (SPY)?
  3. Use a call option on the Volatility Index ($VIX) to hedge against a market decline?
  4. Use shares of the inverse S&P ETF (SH) to hedge against a market decline?”

Wow, there is a lot to digest there. We started our response by stating that the best hedge against shares of stock is a direct insurance policy. Buying a put option against the shares insures against the downward movement on the stock directly reducing the loss that might be taken. Put options on broad market indexes or ETFs or using inverse securities such as the $VIX or SH do not insure shares of stock directly, but rather hedge against large market declines and unexpected events.

But, to go more in depth, we then reviewed the four possible insurance policies and entered them into the PowerOptions portfolio.

Insurance #1 – Married Put

Following the RadioActive Trading guidelines we navigated to the Married Put tab and opened the Search By Symbol tool. We then looked for a put option that was at least 150 days out in time, was slightly In-The-Money and had an at risk amount between 2-8%.

January 14th, 2014:

Buy 100 shares of GE at $26.75
Buy 1 JUN 28 put @ $ 2.02
Total Invested = $28.77 ($2,877.00 total invested per 100 shares)
Guaranteed Exit = -$28.00
Total At Risk = $ 0.77 or 2.7%

Purchasing the JUN 28 put option gives us the right to force someone to buy our shares of stock at $28.00 at any time between now and expiration. We do pay a premium for the put, but only $0.77, the time value, of the $2.02 purchase price is at risk. The remaining $1.25 of the put premium, the intrinsic value, we are guaranteed to get back. This position is much more secure than a Stop Order which can be violated in the case of a pre- or after market gap down in price.

Insurance #2 – Purchasing a Put on SPY

Since GE is part of the S&P 100 as well as the S&P 500, purchasing a put option on the S&P Index ($SPX) or the ETF (SPY) should help to hedge the shares of stock in case of an overall market decline.

Looking at the Option Chain we selected the April 176 put on SPY:

January 14th, 2014, SPY @ $183.67:

Buy 1 APR 176 SPY put @ $2.48

If there is a systemic market decline the SPY put will gain in price. This will hedge the loss against shares of GE. The APR 176 put is $7.67 Out-of-the Money, so the $2.48 put premium is all time value. This does increase the monetary risk of the hedge, but the total investment of GE shares + the SPY put would be comparable to the married put position:

GE RPM Total Investment = $2,877.00 (Case #1)
GE hedged with SPY Investment = $2,675.00 (shares of GE) + $248.00 (SPY put) = $2,923.00

If we went further OTM to identify an SPY put with a cost of $0.77 (the at risk amount on the RPM) we would have selected the $166 strike. This option is close to 20 points OTM and the insurance would not kick in unless there was a significant market decline. To keep the total costs of the positions close, we went with the APR 176 put.

Insurance #3 – Buying a call option on the Volatility Index ($VIX)

The $VIX is an inverse security to the general market movement. If the market is up volatility will decrease and the value of the $VIX will also decline. If the market declines, volatility will increase and the $VIX will rise. Since we can’t purchase shares of $VIX, we have to purchase an option that will increase as the $VIX increases, which happens when the market declines.

Using the Option Chain again, we selected:

January 14th, 2014, $VIX @ $12.28

Buy 1 APR 14 call @ $2.55

Again, this $VIX call was selected to keep the total cost basis of 100 shares of GE + the insurance cost close to the same as the married put and shares of GE + SPY put.

GE hedged with $VIX Call = $2,675 (shares of GE) + $2.55 (SPY put) = $2,930.00

Insurance #4 – Hedging GE with 10 shares of SPY Inverse ETF (SH)

Another ‘option’ to hedge a long stock position is Inverse ETFs which trade counter to changes in the broad based Indexes and ETFs. If the market declines the Inverse ETFs will gain in value helping to minimize losses in a stock position or entire portfolio One could also invest in call options on the ETF, but in this scenario the investor wanted to evaluate hedging shares of GE with just

January 14th, 2014, SH @ $25.50

Buy 10 shares of SH @ $25.50

Purchasing 10 shares of SH would result in an additional cost of $255.00. This is equal to the monetary cost of the $VIX call and pretty close to the additional cost for insuring shares of GE with a put option on SPY.

GE hedged with shares of SH = $2,675(shares of GE) + $255(10 shares SH) = $2,930.00

Comparison of Insurance Hedges:

At the close of business on March 12th, 2014, close to 60 days into the trade, GE was trading at $25.76. This is a decline of -$0.99, or roughly -3.7%.

During this same time period SPY increased from $183.67 on Jan. 14th to $187.28. This is a gain of +$3.61 or roughly 2.0%. Uh-oh. Our stock declined but the ETF went up in price. This means that our put option on SPY would decrease and not be an effective hedge against the loss on GE. This is a fundamental problem using an Index or ETF to hedge your position. It may not track your underlying stock over the same time period. What’s worse, you may have a large decline in your stock due to a bad earnings announcement but the Index or ETF could be increasing resulting in more losses.

Well, with SPY increasing that means that the Inverse ETF, SH, would have to decrease over the same time period. On March 12th shares of SH closed at $24.78, down -$0.72 or -2.8% from the initial purchase price. Insurance #4 looks like it did not work as a proper hedge, either.

Although the broad market was up over this time, the volatility also increased likely due to fear being introduced into the market – perhaps over global concerns with events in Ukraine and other economic issues. On March 12th the $VIX closed at $14.47, up +$2.19 or roughly 17% from the price on January 14th. This seems like it would be the best hedge against the GE position. However…

Liquidation Values on March 12th, 2014:

Insurance #2 – Purchasing a Put on SPY

Sell to close shares of GE @ $25.76 (per 100 shares)
Sell to close SPY APR 176 put @ $ 0.74
Total Liquidation Value = $26.50
Original Cost = -$29.23 (per 100 shares)
Liquidation Loss = -$ 2.73 or -9.4%

This ‘hedge’ would have resulted in a loss of close to -10% had we liquidated GE and the SPY put on Wednesday, March 12th.

Insurance #3 – Buying a call option on the Volatility Index ($VIX)

Sell to close shares of GE @ $25.76
Sell to close 1 APR 14 $VIX call @ $ 2.30
Total Liquidation Value = $28.06
Original Cost = -$29.30 (per 100 shares)
Liquidation Loss = -$ 1.24 or -4.4%

Even though the $VIX option increased by 17% over this time period, the $VIX calls decreased by -$0.25 per contract. This is an issue with using the $VIX options as a hedge during certain markets. Although the $VIX increased we still saw a decline in our $VIX call.

Insurance #4 – Hedging GE with 1 share of SPY Inverse ETF (SH)

Sell to close shares of GE @ $25.76 ($2,576.00)
Sell to close 10 shares SH @ $24.78 ($247.80 for 10 shares)
Total Liquidation Value = $28.24 (avg. per 100 shares)
Original Cost = -$29.30
Liquidation Loss = -$ 1.06 or -3.7%

In this scenario shares of SH dropped by -0.72 per share, but since only 10 shares were purchased the monetary loss is only -$7.00 in addition to the -$99.00 loss on the shares of GE. We did not effectively hedge against the decline in GE, but we did not lose as much compared to the $VIX call or SPY put insurance policies.

Insurance #1 – Married Put
What about the Married Put position? GE declined in price, so our put has to increase in value. This is the only hedge that is a guaranteed relationship. If the underlying declines, a put on that underlying security will increase, especially if the put is In-the-Money. Out-of-the-Money put options may not see as much of an increase which is why we use put options that are OTM and far out in time.

Sell to close shares of GE @ $25.76
Sell to close JUN 28 put @ $ 2.60
Total Liquidation Value = $28.36
Original Cost = -$28.77
Liquidation Loss = -$ 0.41 or -1.4%

The -$0.99 loss on GE was minimized by the +$0.58 gain on the put option ($2.02 to $2.60). Of the four possible hedges, only the Married Put effectively countered over 50% of the loss we would have realized on GE.

In this particular example it is clear that the best hedge for the GE shares from January 14th through March 12th would have been the Married Put position. Using put options on an Index or ETF, calls on the $VIX or even buying shares of an Inverse ETF may work to hedge a stock holding or a portfolio in different markets. However, in this case, a blue chip stock such as GE moved in the opposite direction from the general market. Even a 17% increase in the $VIX did not help our $VIX call counter the loss taken on our shares of stock. For other examples of Stock vs. Portfolio insurance see our previous article:

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