The Hedge

Henry Jennings I have written on the delights of having a small hedge in times of trouble and have had many emails asking for what level of hedging you should have? The answer is easy. It depends. Very JP Morgan when asked about where he saw the markets going. ‘It will be volatile’. The question though is important, and it does depend on how perfect you want your hedge to be? In a perfect world, the hedge will pay out the equivalent of the losses if the worst happens. The issue comes though, of how much the perfect hedge costs and does that mean that there is no upside as the hedge loses when the rest of the portfolio makes money. The really perfect hedge is a low-cost insurance policy that protects in extreme times. I wrote about riding a motorbike without a helmet last week. Putting on a helmet gives you a level of protection but to give complete protection you would need an inflated suit, able to withstand any crash and any car pulling out from that side street. Trouble is riding around in an air bubble of softness that takes away the experience of riding a motorbike. So, with a hedge, it has to provide some level of protection at a manageable cost without clawing away on the performance of the portfolio. It is about stock picking after all. In the Small Cap Portfolio (SCP), I used a 5% allocation to BBOZ which is a geared product. It moves around 2.5 times the underlying ASX 200. A percent in the index is 2.5% on the BBOZ. Roughly. The 5% weighting in BBOZ is far from perfect. It does not take the risk out, it just gives some limited protection. If you are more bearish you can add to the position. The beauty of using a hedge on the index is that you can keep riding the bike. You do not trigger any CGT issues or have to pay brokerage on selling 30 stocks and then buying them all back when your view changes. There are other ways to hedge. Index Puts are probably the simplest and cleanest hedging option and many investment professionals will use options to hedge exposure. You could sell calls and take advantage of high-risk premiums, but the protection that gives you is limited to the amount of premium you have sold for. In an extreme move that may not be enough. Let’s have a look at a quick example of an Index Put:

• Assume we want to have some extreme downside protection. The ASX 200 is 5720 as of last night and the 5500 Put for September closed at 265 points. Each point is worth $10. They are cash settled; option expiry dates cover all the months. I have picked September as an example.
• So that 5500 Put Option will cost $2650 to buy. The Put becomes profitable (at expiry) at 5500 minus 265 points or 5235. There is a lot of time value in that option price and high volatility means it costs more to buy that insurance. A bit like losing your no claims bonus after a bike crash.
• Now assume you have a portfolio and you wanted to protect it against a big move, the 5500 Put as above may be an option. 5500 is the strike price, but there are many alternatives (the strike price you pick depends on your level of bearishness).
• Options have a Delta much like the BBOZ. This is the multiplier if you like. It is how much an option should move in comparison to the underlying asset. In the case of the Sept 5500 Put, it has a Delta of 0.37 (this is formed from a complicated mathematical formula for option pricing called ‘Black and Scholes’). So, if the Index drops 100 points the Put should go up by 39 points. And importantly vice versa. So, if you have a Portfolio worth say $100,000 a 100-point fall will cost 1.7% or $1700. On the hedge side of things, the Put will make you 39 points x 10 dollars a point or $390. So far from perfect. You would need to buy four times the level of Puts to hedge completely.
• So, when choosing a level of hedging you need to ask how much protection you want? The more you want/need, the more it costs.
• In the example above, assuming you bought four contracts of Index Puts at 265 that would cost $10,600. A 100 point move higher would see the portfolio rise $1700 in value and the options fall by $1560. Almost perfect.

Now option hedging is complicated. There are many variables that I will not confuse you with. You can choose different strikes and different months. There are many factors at play in the pricing of the Index Puts. Time and volatility being the most significant. The longer the option has to run and the more volatile the market, the more the option costs. Just like buying that motorbike insurance, if you want a two-year policy it will cost more and if you have a bad crash record or speeding tickets, again it will cost more. The important thing is if I have piqued your interest then there is plenty of further information on the ASX website on options. There are a bunch of great books too. ‘Options as a Strategic Investment’ is the bible as far as I was concerned. When I was a trainee option trader, I was given this book and told to read it and understand it. It was an investment that paid off. If you have time and interest, then the ASX Options courses are very good. Click here for the courses.