Condor Options

Traders are behaving cautiously today, to say the least, as they suffer through the post-Alcoa, poor-home-sales hangover ahead of the Federal Reserve’s release of the minutes from the FOMC’s March 18 policy meeting. Yet implied volatility, in VIX terms, is up less than 2 percent.

The VIX may be saying that a lot of people think the credit crisis is over and the recession is baked into current market prices, but there are plenty of reasons to remain cautious. Current low volatility is giving option buyers an opportunity to hedge their core long positions with puts.

Assuming we’re long anything at this point, what puts would we use as a hedge, and how many do we need? First, we have to figure out how our portfolio moves in relation to the market. We know that four out of five stocks move in the same direction as the market trend, but by how much? Two numbers can give us a pretty good idea: beta and R-squared.

Beta measures how a stock’s volatility compares to the overall market. Beta greater than 1 indicates higher volatility - i.e., wider swings - and beta less than 1 means the equity is more lethargic. R-squared tells how consistently a stock tracks market movement; the higher the R-squared value, the more likely the stock is to move with the market at any given time.

Okay, by now you’re thinking, What, so now I have to be a statistician? Not unless you get a thrill out of doing overly precise calculations in a futile effort to match reality with theoretical averages. The fact is, beta and R-squared are historical numbers that just give us an idea of how an equity tends to behave. So to determine what our hedge position should be, we’re going to simplify things and ignore R-squared (that is, assume a value of 1, or 100%).

So first, we want to calculate our beta-weighted portfolio value, by multiplying the value of our holdings in each position by the beta of the stock or fund and adding it all up. Say we have three stocks: AAA has a beta of 0.93; BBB is a utility, with beta down at 0.40; and ZZZZ, a volatile tech stock, is characterized by a beta of 2.18. Here’s the calculation, based on the hypothetical holdings shown:

Stock	Total Value	Beta	Beta-Weighted Value
AAA	$21,480	0.93	$19,976
BBB	12,950	0.40	$5,180
ZZZZ	$5,360	2.18	$11,685
Total			$36,841

This means that our risk is about equal to having $36,841 invested in “the market”.

Now we have to choose a proxy for the market. We need an index-based vehicle that is broad and has easily traded options. SPY is the obvious choice, although one might want to use QQQQ for a portfolio that’s dominated by NASDAQ stocks, or IWM for a small-cap portfolio. But for our example, we’ll use SPY.

With SPY trading at around $136.50 per share, our beta-weighted portfolio value is approximately equivalent to holding 270 shares of SPY ($36,841/$136.50); therefore, to adequately hedge this portfolio, we would need to buy 3 put contracts on SPY. Because time is our enemy here, we want to minimize time decay by going as far out as is practical. The December 2010 expiration seems a bit excessive, in terms of both time and money; DEC 2009 looks about right for riding out this bear market with minimal time decay, and if need be, we could always roll out come the fourth quarter of 2009.

Now for the strike price. Because we’re hedging against a major decline, we don’t need to spend the extra 20-some percent to go at the money. At about $10.25 per share, the 123 strike (10% out of the money) is a lot more attractive, but since the S&P 500 has already seen a 20% decline from top to recent bottom, the market may have only another 10% to fall. The 129 strike, at just over 5% out of the money, looks like a good compromise. SPY DEC09 129 puts are trading at around $12.35.

If you think it’s excessive to spend $3,700 (3 × the $1,235 price of each put) to protect a $40,000 portfolio, think of it as homeowners insurance. Your portfolio is a valuable asset that could be wiped out if some kind of financial disaster happens, leaving your retirement in jeopardy. The difference between options and insurance, though, is that you’re likely to get some of your premium back if you decide to sell the policy before it expires. Another difference is that you can sell premium - by selling calls against your holdings - to pay for the premium that’s trickling away over time. So in the end, you’re going to spend much less for this insurance than it first appears.

So if your investment strategy includes holding a core portfolio of long positions through good times and bad, but you’re concerned that there might be another shoe to drop (and this bubble-driven market seems to have more shoes than a centipede), now might be a good time so consider setting up a hedge position, while implied volatility is low. If another sell-off, accompanied by higher volatility, comes, those $12.35 puts are going to look cheap.