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On Options

How to Use Options to Hedge Known and Unknown Events

Learn how to set up options trading strategies that might be appropriate for hedging against unexpected bad news.

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One reason I find options interesting to trade is the abundance of choices available. There are different expirations, strike prices, products, and strategies (i.e., strategies based on many different variables like time value, volatility, and interest rates). But is it possible to use of some or all of these features to construct an options trading strategy that will hedge against bad news—whether expected or unexpected? Let's explore this a little further.

Known events or unknown events

In the markets as in life, there are often "known unknowns" and "unknown unknowns." The former means we know when an event is going to occur; we just don't know what the result will be. Examples of these "known unknowns" are:

  • Earnings reports
  • Drug trial results or FDA panel reviews
  • Economic reports
  • Monetary policy decisions
  • Election results

Other times, we don't know what will occur, when it will occur, or even if it will occur. These unknown unknowns are sometimes called "Black Swans," and they include:

  • Merger and acquisition announcements
  • Terrorist attacks
  • Exchange malfunctions (i.e. Flash Crash)
  • Most natural disasters
  • Insider trading or financial fraud

When can you hedge?

We can hedge against known unknowns, but not against unknown unknowns. We can hedge against a known unknown in a cost effective manner by selecting the appropriate strategy and selecting an expiration date that falls after the particular event.

On the other hand, with an unknown unknown, it would be totally cost prohibitive to maintain a constant state of hedging against all possible adverse events, with uncertain outcomes that may or may not ever happen.

So with this in mind, let's focus on hedging the known unknowns.

The 3 Steps of Setting up a Hedge

Step 1: The first step in establishing an options hedge against a known unknown is to determine when the event will occur. To that end, all the known unknowns I've listed above can all be found on schwab.com in the following locations:


Research

Earnings reports
schwab.com>Research>Stocks>Ticker
Drug trial results or FDA panel reviews
schwab.com>Research>Stocks>Ticker>News
Economic reports
schwab.com>Research>Markets>Calendar>Economic
Monetary policy decisions
schwab.com>Research>Markets>Calendar>Economic
Election results
schwab.com>Research>Markets
Source: schwab.com

Step 2: The second step in establishing an options hedge against a known unknown is to determine what you are trying to hedge against. Most of the time it is a sharp price decline, but it could also be a sharp price spike (if you have a short stock position), a volatility spike (if you have a short option position), a sharp volatility drop (if you have a long option position), a spike or even a drop in interest rates (if you have a bond or treasury related ETF). These five known unknowns typically impact price, volatility and/or interest rates in the following ways:

A. Earnings reports

  • Large price swings in either direction are quite common immediately following earnings announcements.
  • Volatility usually begins to ramp up about one week before earnings, peaking just before the announcement. Volatility can sometimes peak at three to four times normal levels.
  • Volatility usually drops sharply immediately following the announcement.

B. Drug trial results or FDA panel reviews

  • Large price swings in either direction are quite common immediately following announcements. For small biotech companies, for example, moves of -75% or +200% can and have occurred many times.
  • Volatility often begins to ramp up several weeks before FDA announcements.
  • Volatility may drop sharply or only modestly after the announcement depending upon how conclusive the outcome.

C. Economic reports

  • Broad equity and/or bond market (interest rate) price swings are possible immediately following the announcement if an economic report misses consensus estimates. The direction of price moves, however, is hard to determine and it may not make sense to some investors.
  • Volatility tends to lessen immediately before major announcements.
  • Volatility may pick up modestly, immediately after the announcement, unless the report is close to consensus estimates.

D. Monetary policy decisions

  • Bond (interest rate) and/or broad equity market price swings are possible immediately following the announcement if the report differs from expectations. Moves will usually be larger when announcements are unexpected or occur between scheduled meetings.
  • Volatility tends to lessen modestly before major announcements, unless unscheduled.
  • Volatility may increase sharply following unscheduled or unexpected announcements.

E. Election results

  • Market response varies greatly and has historically been inconclusive with regard to election specifics (i.e., political party, first or second term, incumbent or challenger).
  • Volatility tends to lessen modestly before the results are announced.
  • Volatility may increase modestly following results due to future uncertainties.

Step 3: Once you have determined what you are trying to hedge against, you need to select the most appropriate option strategy. The most effective way to do so is using Schwab's Option Strategy Finder tool, which can help you select not only the strategy but also the moneyness (the position of the stock's current price relative to the strike price of the option) and the expiration date. Here are a few guidelines to keep in mind:

  • In the marketplace, volatility tends to drop when equity prices rise. Conversely, volatility tends to rise when equity prices drop, all else being equal.
  • Volatility manifests itself in the time value component of an option price. Since the intrinsic value (if any) is based entirely on the price of the underlying stock, only the time value changes when volatility changes.
  • ETFs and options that are tied directly to volatility and/or the VIX may not provide adequate protection except during times of extreme, broad market volatility spikes. Traditional option strategies that benefit from volatility changes on specific stocks are typically a better choice than broad market volatility-related products.
  • Spreads, collars and other strategies that involve an equal number of long and short options, tend to neutralize much of the impact of sharp volatility changes, so the focus becomes primarily just changes in price.
  • Long options will generally work in your favor when volatility increases, while short options will generally work against you.
  • Conversely, long options will generally work against you when volatility decreases, while short options will generally work in your favor.
  • With long calls and/or long puts, the price change associated with sharp price moves in the underlying stock, can be partially or completely negated by a large drop in volatility.
  • Calls and puts generally decline in fairly equal amounts when volatility drops and increase in fairly equal amounts when volatility increases.
  • Any strategy involving long options, or more long options than short options, will generally benefit from an increase in volatility.
  • Any strategy involving short options, or more short options than long options, will generally benefit from a drop in volatility.

While the variety of hedging strategies available is virtually unlimited, we’ll take a look at five of the most common ones:

Covered calls

Advantages:

  • Provides partial (but very limited) downside protection
  • Costs nothing to implement and even generates a small amount of income
  • Time value erosion will be beneficial when the underlying price is stable
  • Timeframe is limited and the calls may eventually expire worthless

Disadvantages:

  • Downside protection is limited to the amount of the option premium
  • The upside profit potential is substantially limited
  • If your short call options are in the money, you could be assigned at any time
  • Stocks that pay dividends can be especially vulnerable to early assignment

Protective equity puts

Advantages:

  • Provides significant downside protection
  • Has a defined exit price
  • Offers protection even in a market that gaps down
  • Does not require the underlying position to be sold
  • Generally allows for unlimited upside profit potential

Disadvantages:

  • Can be expensive
  • Value erodes over time
  • Timeframe is limited and the puts may eventually expire worthless

Collars

Advantages:

  • Provides significant downside protection
  • Has a defined exit price
  • Offers protection even in a market that gaps down
  • Usually does not require the underlying position to be sold
  • Can often be set up at little or no cost

Disadvantages:

  • Substantially limits the upside profit potential
  • If your short call options are in the money, you could be assigned at any time
  • Stocks that pay dividends can be especially vulnerable to early assignment
  • Timeframe is limited as the options will eventually expire

Put spread collars

Advantages:

  • Provides substantial downside protection for small downside moves
  • Allows for greater upside potential than a traditional collar
  • Usually does not require the underlying position to be sold
  • Can often be done at little or no cost

Disadvantages:

  • Downside losses can be substantial when there's a significant downside move
  • Upside potential is still limited in the event of a significant upside move
  • If your short call options are in the money, you could be assigned at any time
  • Timeframe is limited and the puts will eventually expire

Protective put ratio backspreads

Advantages:

  • Provides catastrophic downside protection against large downside moves
  • Generally allows for unlimited upside profit potential
  • Usually does not require the underlying position to be sold

Disadvantages:

  • Downside losses could be high before protection begins
  • Generally more expensive than traditional collars
  • Costs can be reduced, but only by allowing greater downside risk
  • If your short put options are in the money, you could be assigned at any time
  • Timeframe is limited and the puts will eventually expire

Protective index puts

Advantages:

  • Provides significant downside protection for a diversified portfolio of equities
  • Provides protection even in a market that gaps down
  • Cash settlement ensures that portfolio positions are never sold
  • Often results in favorable tax treatment

Disadvantages:

  • Can be very expensive to use
  • Requires a portfolio with a close correlation to an index that offers options trading
  • Exact quantity required can be difficult to calculate
  • Is usually more expensive during times of higher volatility
  • Effectiveness can be reduced if volatility declines
  • Value erodes over time
  • Timeframe is limited and the puts may eventually expire worthless

Summary

As you can see, each of the many ways to hedge against adverse market movements involves tradeoffs. Consider focusing only on those positions in your portfolio that are historically the most volatile or those that make up a substantial position of your account.

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