There have been a number of high profile market commentators predicting a market crash.
While these predictions make great headlines what is more important for investors is how well portfolios are managed to weather periods of future market turbulence. This got me thinking about how to manage better put option portfolio protection strategies.
Portfolio Protection via Options
One of the simplest way of implementing downside protection via options is buying (‘go long’) an out of the money put option (that is, strike price lower than current price) on a specific index (or security).
The expectation with this strategy is if the index falls and / or volatility increases the put option protection will offset some or all of the losses of the underlying portfolio.
Many of the option protection strategies manage option hedges passively. Using a systematic approach as one put option position nears expiry it is rolled into a put option with a similar longer dated expiry date. This is typically three – six months out in order to reduce the impact of time decay.
The downside to passive hedge management is that when the market has experienced a downturn and volatility has risen (the protection has kicked in), maintaining the portfolio put option hedges would entail rolling out of the profitable put position into new put position that is expensively priced.
The risk is that the overall benefit of a well-crafted portfolio hedge could be reduced with the value of the new put option falling and dragging on overall performance as the market started to stabilize and implied volatility decreased.
Dynamically managing the duration of the portfolio put option protection could mitigate some of the risk of giving back the hedge profits as markets began to stabilize.
Dynamically managing gamma and vega
Dynamically managing the duration of the put option exposure alters the gamma and vega exposure of the portfolio hedges in response to market risk conditions.
Vega is the measurement of an option’s sensitivity to changes in the volatility of the underlying asset. Vega represents the amount that an option contract’s price changes in reaction to a 1% change in the implied volatility of the underlying asset.
Gamma is the rate of change in an option’s delta per 1-point move in the underlying asset’s price. Gamma is an important measure of the convexity of a derivative’s value, in relation to the underlying.
When volatility is low it is preferable for put option hedges to have a greater exposure to vega via longer dated put options. The further out in expiry date the higher exposure an investor will have to vega i.e. the portfolio benefits more from an increase in implied volatility.
Being long vega when volatility is low means that as the market falls not only will the put options start performing due to the downward move but the portfolio will be better exposed to the increase in implied volatility that typically accompanies a market fall thus increasing the value of the hedge position even more.
During a market fall and volatility increase dynamically managing the put protection position entails systematically reducing duration of the put option positions by rolling into put options that are closer to expiry.
For example I use the following rule of thumb when managing portfolio hedges:
VIX at < 13 = Expiry 6 to 12 months out
VIX at 13-16 = Expiry 3-6 months out
VIX at 16-20 = Expiry 2 – 3 months
VIX at 20 > Expiry front month
This reduces the portfolio exposure to vega and increases gamma to the point where markets are going crazy and the portfolio put option duration is the front month expiry.
When markets are at maximum craziness the money will have already been made from the spike in implied volatility so it is preferable to reduce the vega exposure by holding options that are closer to expiry. After all volatility spikes are typically short lived and implied volatility mean reverts fairly quickly.
The gamma exposure would have been increased which is good because with volatility high the market will be moving around a lot.
By dynamically managing the duration of portfolios put hedges the investor has effectively scalped vega and taken some profit and kept the same protection i.e. the same number of contracts. Not a good time to be unhedged.
As the market begins to stabilize an investor would give back some of the gain they made on their hedges, there is no avoiding that if portfolio hedges are to be maintained.
However the objective of reducing the duration of the positioning was to reduce the exposure to vega (the exposure to a change implied volatility) as the market begins to stabilize and implied volatility begins to fall.
Sure volatility could go higher however that is a calculated risk investors have to take.
There is no hard and fast rule on the optimal option duration management strategy. It will vary depending on the general market environment, implied volatility and portfolio positioning.
However a simple tweak to consider in what can be an overlooked part of portfolio management can achieve a better outcomes from investment portfolios.