Options

Using Option Strategies to Help Reduce Event Risk

Many traders know that options strategies provide an abundance of choices. But is it possible to construct an options trading strategy that will hedge against bad news—whether expected or unexpected? The answer is yes and no. Let’s explore.

Known events or unknown events
In the markets as in life, there are often “known unknowns” and “unknown unknowns.” Sometimes, 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 Swan Events,” 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 not hedge against unknown unknowns, as 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 occur.

We can hedge against known unknowns in a cost effective manner by selecting the appropriate strategy and an expiration date that falls after the particular event. So let’s focus on hedging known unknowns.  

Setting up a hedge

Step 1:

The first step in hedging against a known unknown is to determine when the event will occur. The dates of the known unknowns listed above (and many others) can typically be found on any reputable financial website.

Step 2:

The second step in hedging 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 or ETN). These 5 known unknowns typically impact price, volatility and/or interest rates in the following ways:

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, and can sometimes hit three to four times normal levels.

•              Volatility usually drops sharply immediately following the announcement.


Drug trial results or FDA panel reviews

•              Large price swings in either direction are quite common immediately following announcements. With small biotech companies, for example, moves of -75% or +200% are not uncommon.

•              Volatility often begins to ramp up several weeks before FDA announcements.

•              Volatility may drop sharply or only modestly after the announcement depending upon the outcome.


Economic reports

•              Broad equity and/or bond market (interest rate) price swings are possible immediately following the announcement if the report misses the estimates. The direction of the moves is hard to determine and it may not always make sense.

•              Volatility tends to lessen immediately before major announcements.

•              Volatility may pick up modestly, immediately after the announcement, unless the report is close to the estimates.

 

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 announcements.

 

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 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. Here are some guidelines to keep in mind:

•              In the marketplace, volatility tends to drop when equity prices rise and rise when equity prices drop, all else being equal.

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

•              ETFs, ETNs and options that are seemingly tied directly to volatility and/or the VIX may not provide adequate protection except during times of extreme volatility spikes. Traditional option strategies 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 volatility changes, so the focus is mostly on price change.

o             Long options generally work in your favor when volatility increases, while short options generally work against you.

o             Conversely, long options will generally work against you when volatility decreases, while short options generally work in your favor.

•              With long options, the price change associated with sharp price moves in the underlying stock, can often be partially or completely negated by a large drop in volatility.

o             The prices of calls and puts generally increase and decrease in fairly equal amounts when volatility changes.

o             Strategies involving long options, or more long options than short options, will generally benefit from an increase in volatility.

o             Strategies 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, here are a few of the more 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

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


In Summary
All hedging strategies involve tradeoffs. Consider focusing on those positions in your portfolio that are historically the most volatile or those that make up a substantial percentage of your account.

Randy Frederick can be contacted at Schwab Center for Financial Research

Randy Frederick is Managing Director of Trading and Derivatives with the Schwab Center for Financial Research. He is one of the early architects of Schwab's option trading platforms and analytics tools. While he focuses primarily on public relations, client education and market analysis, he is frequently involved on matters of business development, product development and risk management. He has served on various corporate and industry committees including the FISD Executive Committee, the ISE Allocation Committee and the ISE Board of Directors.

Randy is a respected industry veteran with more than 25 years’ experience who writes blogs and educational articles for Schwab's website and client newsletters. He was the host of the weekly radio show "The OPTIONal Hour" on TFNN from 2005 – 2007 and he has been published in trade magazines such as Active Trader, Futures & Options Trader, SFO and Futures. He is a frequent guest on CNBC, Fox Business and Bloomberg TV, and his comments often appear in the financial news media including The Wall Street Journal, Barron's, the Financial Times, Bloomberg, Dow Jones, Reuters, USA Today, Forbes.com and TheStreet.com.