Download the Schwab app from iTunes®Get the AppClose

Hedging in the Midst of a Bear Market

Hedging before the bear market arrives is possible, if the bear market is caused by a “known-unknown” event. But hedging before an “unknown-unknown” isn’t as simple. Here’s the difference:

Known vs. unknown events

Most corrections and bear markets are caused either by known-unknowns or 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—also called a “black swan” event—can include:

  • Merger and acquisition announcements
  • Terrorist attacks
  • Exchange malfunctions
  • Unexpected natural disasters
  • Insider trading or financial fraud
  • Pandemics


When can you hedge?

You can hedge anytime, but while you can anticipate known-unknowns, you cannot anticipate unknown-unknowns. And since down markets usually begin as pullbacks (declines of less than 10%), progress into corrections (declines between 10% and 20%), and then sometimes become bear markets (declines of over 20%), the bottom doesn’t usually arrive immediately.

The good news is there are options strategies you can use after the decline has already started. First, let’s review volatility and typical behaviors of common option strategies.

What is volatility?

Volatility is a measure of movement, not a measure of direction. However, in the marketplace, volatility tends to drop when equity prices rise, and rise when equity prices drop, all else being equal. When the Cboe Volatility Index (VIX) is elevated, prices of options (calls and puts) in general tend to be more expensive.

Volatility manifests itself in the time value component of an option price. Since the intrinsic value (in-the-money amount), if any, is based entirely on the price of the underlying stock/ETF, only the time value changes when volatility changes.

Common behaviors of option strategies

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, allowing the focus to become almost entirely directional (based on price). Long options or any multi-leg strategy involving more long options than short options will generally work in your favor when volatility increases, and against you when volatility decreases. Conversely, short options, or any multi-leg strategy involving more short options than long options, will generally work against you when volatility increases, and in your favor when volatility decreases.

With both calls and puts, the price change associated with a sharp price move in the underlying stock can be partially or completely negated by a large change in volatility.

With these factors in mind, let’s review how some of these strategies may be useful during a correction or bear market.

Covered calls

A covered call is a very common strategy that involves selling a call option with a strike price that is usually out-of-the-money, against an existing stock or ETF position. In the early stages of a decline, volatility may increase, which can make prices on covered calls more favorable. Selling covered calls can be a good strategy as long as you select a strike price at which you would be willing to allow your stock to be called away. But if the price of the underlying stock/ETF declines substantially, covered calls are unlikely to provide sufficient downside protection, even if the calls expire worthless.

With current volatility so high, out-of-the-money covered calls may be priced favorably right now. Just be sure to choose a strike price at which you’re willing to let the stock go. And since you may not be able to forecast the duration of the black swan event, consider using a longer dated expiration than you would ordinarily use. Once the situation calms down, volatility is likely to fall, and out-of-money calls are likely to lose a lot of value.

Example:

Long 100 shares of XYZ (already owned @ 55.00)

Short 1 XYZ Jun 60 call @ 1.00

Advantages

  • Provides partial (but very limited) downside protection.
  • Aside from transaction fees, costs virtually nothing to implement and even generates a small amount of income.
  • Time value erosion is 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, which means your stock will be automatically sold at the strike price of the call.
  • Stocks that pay dividends can be especially vulnerable to early assignment.
     

Protective puts

A protective put is a strategy that involves buying a put option that is usually out-of-the-money to protect an existing stock or ETF position. In the early stages of a decline, if volatility hasn’t increased too much, protective puts may still be an effective way to protect your downside. But if you wait until a deep correction or bear market has already begun, protective puts are likely to become prohibitively expensive. Note that options are not available for all securities, and, because they require real-time pricing, protective puts cannot be bought on daily-priced mutual funds.

Example:

Long 100 shares of XYZ (already owned @ 55.00)

Long 1 XYZ Jun 50 put @ 1.10
 

Advantages

  • Provides downside protection from the strike price all the way to zero.
  • Has a defined exit price at the strike 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 on the underlying security.
     

Disadvantages

  • Can be expensive, especially as volatility increases.
  • Value erodes over time.
  • Timeframe is limited and the puts may eventually expire worthless.
  • Will generally lose value if volatility decreases. 
     

Collars 

A collar is a two-legged strategy that involves buying long puts and selling short calls on an existing stock or ETF position, usually both out-of-the-money. And since you are buying and selling at the same time, volatility levels usually have little impact on the cost of this strategy, thus making this a useful strategy in any market environment. If the puts become expensive as the volatility increases, the calls will too. While collars do limit your upside potential, that is usually not a great concern during corrections and bear markets. Just be sure to follow the covered call rule, and only select a strike price (on the calls) at which you would be willing to allow your stock to be called away.

Example:

Long 100 shares of XYZ (already owned @ 55.00)

Long 1 XYZ Jun 50 put @ 1.10

Short 1 XYZ Jun 60 call @ 1.00

Advantages

  • Provides downside protection from the put strike price all the way to zero.
  • Has a defined exit price at the put strike 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.
  • Generally not impacted greatly by changes in volatility.
     

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.
     

Vertical put spreads

A vertical put spread involves both long and short options (buying puts and selling puts), so volatility levels usually have little impact on the cost of this strategy, thus making this a strategy that can be used in any market environment. If the long puts become expensive as the volatility increases, the short puts will too. While vertical put spreads allow you to specify how much downside protection you desire, and how much you’re willing to pay, they cannot provide as much protection as protective puts. 

Generally, you should avoid buying puts outright when volatility is too high. But if you spread them out, you may be able to eliminate most of the volatility component.

Example:

Long 100 shares of XYZ (already owned @ 55.00)

Long 1 XYZ Jun 50 put @ 1.10

Short 1 XYZ Jun 45 put @ 0.40

Advantages

  • Provides a precise level of downside protection for a modest price.
  • Downside protection is limited to the difference in the strike prices of the two options.
  • Less expensive than protective puts.
  • Provides limited protection even in a market that gaps down.
  • Does not require the underlying position to be sold.
  • Generally allows for unlimited upside profit potential on the underlying security.
  • Generally not greatly impacted by changes in volatility.
     

Disadvantages

  • Provides less downside protection than protective puts.
  • Generally requires holding until expiration to realize most profit potential.
  • Timeframe is limited, and the puts may eventually expire worthless.
     

Put spread collars  

A put spread collar is a sophisticated three-legged strategy that involves the purchase of a long (protective) put and the sale of a short (covered) call as with a regular collar—except with the put spread collar, the long put position can be purchased much closer-to-the-money than the short call position, and the difference in price is offset by the sale of a farther out-of-the-money put position. This structure allows for much greater upside potential, with far less downside risk when there is only a small decline in the price of the stock. However, if there is a sharp decline, downside losses could still be significant.

A put spread collar is essentially a covered call combined with a bearish put spread. Just be sure to follow the covered call rule, and only select a strike price (on the calls) at which you would be willing to allow your stock to be called away. As a result, this strategy may be worth considering when you believe the market decline may be getting close to a bottom and a rebound might be approaching soon.

Example:

Long 100 shares of XYZ (already owned @ 55.00)

Long 1 XYZ Jun 50 put @ 1.10

Short 1 XYZ Jun 65 call @ 0.55

Short 1 XYZ Jun 45 put @ 0.40

Advantages

  • Provides a reasonable amount of downside protection at a very low cost.
  • Net cost is the purchase price of the long option less the proceeds of the short options.
  • Downside protection is limited to the difference in the strike prices of the two put options.
  • Allows for greater upside potential than a traditional collar.
  • Usually does not require you to sell the underlying position.
  • 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.  
     

Bottom line

While these strategies provide tremendous flexibility, like most option strategies, each one also involves tradeoffs. When trying to decide which positions you should hedge, consider focusing on positions that are historically volatile or that make up a substantial portion of your overall account; or focus on the position that concerns you the most.

What You Can Do Next

  • Read more about Schwab’s perspective on recent market volatility.

  • Schwab clients, please reach out if you’d like discuss your portfolio.  Contact your Schwab Financial Consultant or call 877-807-9240 to speak with a Schwab trading specialist.

  • If you’re not a client, learn more about trading at Schwab.

Loss, Strain & Butterflies: Earnings Plunging, Stocks Ignoring
Loss, Strain & Butterflies: Earnings Plunging, Stocks Ignoring
Should You Refinance Your Mortgage?

Important Disclosures:

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the Options Disclosure Document titled Characteristics and Risks of Standardized Options before considering any option transaction. Supporting documentation for any claims or statistical information is available upon request. 

Past performance is no indication (or "guarantee") of future results. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. 

Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies. 

The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Examples are not intended to be reflective of results you can expect to achieve.   

With long options, investors may lose 100% of funds invested. Multiple leg options strategies will involve multiple per-contract charges. Spread trading must be done in a margin account. Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.  

Investing involves risks, including loss of principal. Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss. 

Charles Schwab & Co., Inc. ("Schwab") (Member SIPC). 

(0420-07D9)

Thumbs up / down votes are submitted voluntarily by readers and are not meant to suggest the future performance or suitability of any account type, product or service for any particular reader and may not be representative of the experience of other readers. When displayed, thumbs up / down vote counts represent whether people found the content helpful or not helpful and are not intended as a testimonial. Any written feedback or comments collected on this page will not be published. Charles Schwab & Co., Inc. may in its sole discretion re-set the vote count to zero, remove votes appearing to be generated by robots or scripts, or remove the modules used to collect feedback and votes.