February was a good test run for the inevitable market downturn. After being on cruise control for approximately two years the fear of inflationary pressures combined with quickly rising rates spooked the market resulting in a quick 10% drop. Sometimes when these “jolts” occur, other risks that may not have been appreciated or at least properly priced are exposed. For example, in 2008, auction rate securities quickly illustrated a risk not appreciated by investors. In the brief but violent downturn experienced this February, the risk of being short volatility was exposed. While the initial downturn was due fears of increasing rates and inflationary pressures, it was exacerbated by a lack of prudence or at least respect for the short volatility trade – an exposure that kept on giving for the last two years before taking it all back and a lot more in a single day. It is helpful for investors to remember just how violent the markets move when dislocations occur allowing for a reassessment of their market exposure and incorporation of potential hedges.
Trailing Stops Create a Binary Decision Tree
A popular hedging strategy amongst many investors is the trailing stop order. Investors tend to stick a level below the market, regularly adjusting the stop order level higher as the market increases. There are two potential detriments with this form of hedging. The more serious of the two is the binary decision tree that it creates. Once a stop is executed the investor no longer has exposure to the market. At that point a decision needs to be made of when to get back in as well as where to set a new stop order. Psychology begins to play a large role as many decisions in a heated market are necessary. The investor is now a tactical manager with all the benefits and negatives that come with it. The most recent V shaped downturn would have been exceptionally hard to navigate. The second issue is that a trailing stop order will not protect from a gap down open where an investor may lose materially more than anticipated based on their stop order.
An Options Strategy as a Possible Solution
Another solution is to use an option strategy. With an option strategy, one is able to turn that binary decision in regards exposure into a more flexible approach. Owning a downside put provides two key benefits and one key detriment when compared to a stop order. First, the benefits: A put contractually allows the owner to sell a stock at an agreed upon price. Furthermore, the owner does not need to trigger the put to sell but rather can wait until the put expires to make their decision to sell. As a result, the owner of the put is able to maintain exposure above a certain level while protecting exposure below it – a pretty nifty trick that averts the need to make multiple binary decisions (e.g., in or out). The one negative as compared to a stop loss order is the cost which we will tackle shortly.
Trailing Stops vs Option Strategies
The recent market drawdown provides a good canvass of which to illustrate the differences in these two hedging strategies. Let’s say investor A placed a stop order on SPY at $272 and investor B purchased a put with a strike of $272. On February 5th, SPY dropped through the $272 level closing at $263.93. At this point Investor A no longer has exposure to SPY. Investor B is protected below $272 but still has exposure above $272. Investor A now needs to make a decision of when to re-enter the market. Furthermore, upon re-entering, Investor A also now needs to decide where to reset their stop order.
If instead of initially setting their stop and put levels at $272, both investors set levels at $258 then Investor A would have had almost no ability to re-establish exposure to the market prior to the bounce back. In a V shaped recovery it is increasingly hard to make the decision of when to get back in. Multiple decisions must be made. Meanwhile, Investor B can simply monitor the market as they are protected below the put level but have full exposure above it. There are no tactical decisions necessary.
Another advantage options have over trailing stops is in protecting against an opening gap down. If for example SPY gapped down on the open of February 5th to $264 while Investor A had a stop order at $272, then the stop order would have been filled at $264 rather $272. Puts are impervious to gap opens. In summary, gap drops and decision making are two real detriments to contend with when using stop orders as a hedging tool.
Option Strategies in Practice: Costs & Opportunities
The detriment of a put, which is essentially an insurance policy on the market, is that it can be costly – like insurance. There are a number of option strategies that help mitigate the cost, such as a zero-cost collar where one offsets the costs of the downside put by selling an upside call. The downside put protects from a negative market event while the upside call will limit returns above it. Markets typically move down much quicker then up so the art is really in trying to capture a reasonable return while protecting ones-self from a violent downturn.
Options can be hard to use however. And for advisors, complexity is added due the need to incorporate the product into a portfolio of client accounts due the complexity and regulation surrounding the product among other difficult characteristics. In short, they are not easy products to use.
Option based Mutual Funds and Structured Notes – Using Packaged Option Strategies
There are a number of other ways to take advantage of options though. There has been a growing number of option strategies in mutual fund and ETF format. In fact, Morningstar recently introduced an options category, and while the category is wide, there are a number of option strategies providing that downside hedge.
Another vehicle that takes advantage of options are structured notes (aka equity-linked notes). Structured notes provide a very defined outcome though only as measured from the day one enters to the day that the product matures. More importantly, structured notes allow the investor to customize their exposure by setting a defined level of hedge on the downside as well as participation up. For example, one popular product provides protection on the initial 10% downside losses of the S&P while providing participation up to a cap of let’s say 8% over a year. Structured note exposures are primarily dictated by underlying options though these are debt securities so purchasers should be aware of the credit risk inherent with the issuer.
In summary, there are a few different ways to utilize options within a portfolio ranging from the do-it-yourself approach using individual options to mutual funds which are generally the easiest to use, especially within model portfolios. As compared to using a stop loss strategy in hedging downside, options are able to provide the best of both worlds in protecting an investment while still maintaining exposure to the upside.
 A V shaped downturn is one where the market moves violently down and then immediately makes a recovery
 A gap down open is one where the market opens down a material amount not providing the opportunity for investors to sell between prior day close and new market level