Options, Hurricanes and Hedging

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The purpose of my scribbles is not to provide you with a fish but to teach you how to fish (though sometimes some fish will sneak in). The scribble I am about to share with you I wrote to IMA’s (the firm that employs me) clients in January 2018. Its purpose was to explain why we were going to start hedging their portfolios with put options. IMA’s clients are sophisticated individuals (this is why they hired us J), but they are not investment professionals (this is why they hired us). Therefore, I wrote this as much as to educate about stock options as to explain what we were about to do.

Let me make this point crystal clear: When I was writing this I did not know that volatility was going to explode in two weeks. Volatility going from a multi-year low to a multi-year high within two weeks of this writing was a fluke. The worst thing I could possibly do would be to convince myself that I am Nostradamus and that I have learned how to time markets. I am not and I did not. You cannot put market timing into a repeatable (key word) process – market behavior in the short run is too random for that.

The math used in the example below is already irrelevant, and we are not putting on hedges today for new clients (so no fish here). However, the educational component of this letter is evergreen. Also, at some point in the future volatility will be cheap again and the strategy I describe in this letter will be actionable.

Options, hurricanes and hedging

We always look at our investment process and ask ourselves, “What can we do better?” How can we increase returns and lower risk? We think we have found a new, sensible way to do both.

We can hedge a portion of our market exposure with put options. Put options are contracts that trade on an exchange that give buyer (us) a right, not an obligation, to sell stock (or in our case Exchanged Traded Fund, ETF that mimics a market index) at a specific price for a certain period of time. Put options are cash settled, so when we exercise it or it expires we get cash in lieu of its value. Buying put options is very similar to buying hurricane insurance. We pay a premium, and that is the only cost we bear. Let’s restate this: The only risk we take is that the hurricane doesn’t hit or, in our case, that the stock market doesn’t decline, in which case our premium was “wasted.”