Use straddles to hedge against noise

The best way to mitigate volatility spikes is to buy index straddles when volatility is low. A straddle involves the simultaneous purchase of a call and a put on the same underlying index with the same strike price and expiration date. The straddle is a non-directional volatility trade: the call will make money in a rising market; the put profits in a declining market. This strategy generates a profit if the underlying index moves up or down by an amount greater than the combined cost of the call and the put.

For instance, at the time of writing, depositary receipts on the S&P 500 composite index (symbol: SPY) were trading at $169.31. (All figures are in U.S. dollars.) The SPY January 170 call was trading at $5.20; the SPY January 170 put was at $7.45. The total cost to buy both the call and the put was $12.65 (or $1,265 per contract).

The trading range implied by the SPY 170 straddle is 182.65 on the upside and 167.35 on the downside. That trading range is calculated by simply adding the two premiums to the strike price (to determine the upside target) and subtracting the two premiums from the strike price (for the downside target). The straddle profits if SPY breaches either end of that trading range at or prior to the January expiration.

The index straddle also can profit if volatility spikes because volatility is one of the major inputs in the options-pricing formula that affects calls and puts equally. Premium levels for both calls and puts increase when volatility expands and decrease when volatility contracts – and therein lies the rationale for entering into this trade when volatility is low.

At the time of writing, the Chicago Board Options Exchange‘s volatility index (symbol: VIX) was trading at $13.41, which equates to an annual volatility assumption of 13.4%. That’s well below the 22% mark VIX hit at the end of June, when Ben Bernanke, the Fed’s chairman, first hinted at tapering just prior to the start of the second-quarter earnings parade.

But does 13.4% constitute low volatility? To address that question, we first must define “normal” volatility. For that, I tend to look at VIX’s 50-day moving average because it reflects different market environments and removes much of the day-to-day noise. If you buy into this concept of “normal,” then volatility is low when the daily VIX is below the 50-day moving average. The 50-day average at the time of writing was about 15.2%.

Your objective with the long index straddle is to incorporate volatility as a negatively correlated, non-directional asset class within a broadly diversified portfolio. That’s especially relevant now, as most analysts don’t believe traditional portfolio diversifiers such as bonds will offer much protection. And because volatility as an asset class is about six times more volatile than equities, a few long straddles can do the work of many.

How much of a portfolio should be committed to the straddle hedge? The answer rests with the dollar value of the equities assets. Suppose your client has a $500,000 portfolio with 70%, or $350,000, invested in equities. A 1:1 hedge requires you to hold straddles for which the underlying value is equal to approximately $350,000. Each January 170 straddle represents about $17,000 of equities value (i.e., $170 strike price x 100 units per contract = $17,000).

Theoretically, 20 straddles at a cost of $25,300 would approximate a 1:1 hedge on the equities assets within the portfolio. But as volatility is six times more volatile than equities, you could reduce the 20 contracts by a factor of six, which would reduce the number of contacts to three or four at a cost of $3,795-$5,060.

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