Hedging with options
A hedge is insurance with a premium. It lowers expected return and caps losses in exchange, and it's only worth it if you know the cost.
Learning objective: After this lesson, you can judge when hedging with options is worth its cost.
The simplest hedge is a put on the index you hold. If the market falls, the put rises in value and offsets part of the loss.
That sounds like a good idea, and like any insurance, it's a cost question. Hedge your account permanently, and you pay a premium year after year that eats up a substantial share of your return over long periods.
That's why permanent hedging usually isn't a sensible solution for retail investors. If you can't stand the fluctuation, better to permanently lower your equity share. That costs nothing and works reliably.
Hedging can make sense in special cases: when a known date is coming up when you'll need money, or when a single holding makes up a very large share of your wealth.
Hedging via puts acts like insurance with an ongoing premium. Over long periods, the sum of premiums is substantial, since implied volatility on average sits above realized volatility. This gap, the volatility risk premium, gets paid by the hedge buyer and is the structural reason why permanent hedging reduces returns.
Costs can be reduced through structures, such as simultaneously selling an option at a different strike. Such structures lower the premium and cap the gain in exchange, or introduce further obligations. Cost-free hedging doesn't exist, only redistribution of the payoff profile.
Effectiveness depends on how well the hedging instrument matches the hedged holding. Basis risk arises when the index and the portfolio are composed differently. Also, a hedge only works for its term, so recurring renewal is needed, and its cost depends on market conditions and is highest right after a decline.
Summary
- Permanent hedging costs substantial return over the years.
- A lower equity share achieves the same and costs nothing.
- Hedging is most expensive exactly when you want it most.
Did you get it?
Why does permanent hedging reduce returns?
Because implied volatility on average sits above realized volatility, and the buyer pays that premium.
Does cost-free hedging exist?
No. You can only redistribute the payoff profile, for instance by capping the gain.
What's the simpler alternative for retail investors?
A permanently lower equity share.
Check your understanding
Sources and further reading
- A Federal Reserve research paper examines the variance risk premium, the gap between implied and realized volatility that buyers of ongoing option hedges pay for. View source ↗
Related
- Options: calls and putsStage 5
- What return actually meansStage 1
- RebalancingStage 5
- Matching questions for this stageQuestions