Choosing Direct Vs. Indirect Hedging

By Chris McKhann

Diversification has long been touted as the best tool to manage risk, and it can be in some respects. But it can be very disappointing to find that in times of crisis your "diversified" assets have a correlation of 1--which means that they will all go down together. It is for just that reason that direct hedging can often be the best approach.

Correlations between stocks and indexes are near an all-time high, as they often are in difficult economic times. So you are better off owning indexes than individual stock picking for the time being (though that can change quickly, as David notes in his column).

That poses an equally difficult problem in hedging because traditional safety plays such as gold or bonds can move in the same direction as equities at the very times you most want them not to.

This is why the VIX has been described as the best hedge. The inverse correlation with the S&P 500 is very high, as much as 85 percent by some measures, and gets even higher when the market sells off. That means the VIX spikes when the market tanks.

Unfortunately, one cannot buy the VIX itself, something that would make our investing lives much easier. And the tradable VIX-related products--futures, options, and exchange-traded funds and notes--are not ideal hedges, and their complexities make them truly useful to a limited few. Even though they too have a very high inverse correlation to the SPX, their various costs make implementation and strategy selection near impossible.

So we return to equity options. If you own a concentrated position in one stock, a basket of stocks, or an ETF, the most direct hedge is simply to buy puts in those assets. That way you can be that you are insuring exactly what you want to.

Such put protection is guaranteed to kick in at a certain point if those assets fall far enough, as the premiums for these options rise when their underlying tanks. This occurs both because of the move in the underlying's price and the increase in volatility, which benefits long options. (See our Education section)

Like any insurance, of course, there is a cost involved. That is the biggest issue in buying puts as a direct hedge. But you do get to choose your premium, your deductible, and the term of your insurance. This means that, unlike your car or life insurance, you can have a much better idea of the relative cost of this protection if you understand the volatility data.

The problem is that that relative cost is usually pretty high and can significantly cut into your portfolio's performance. That's why traders turn to put spreads, out-of-the-money calendar spreads, or other instruments aimed at reducing the cost of the protective position.

The problem with these strategies is that we are back in the land of questionable correlation. Some of these strategies will cap potential gains in the case of a selloff, limiting the hedge to a certain range. Others are making bets on relative moves or on the timing of those moves.

There is no reward without risk. But good option traders focus on the risks that they want to take--and avoid the ones they don't.