Traders have had a love affair with index options ever since the Chicago Board Options Exchange® (CBOE) introduced the S&P 100 options (OEX) in 1982. However, among index products, arguably the most popular is still that of the S&P 500 (SPX), particularly when it comes to using its options to help hedge portfolios. But, for the past three decades, a problem unique to “a.m. settled” options, such as those on SPX, has challenged investors who rely on SPX options as a hedge. The cries have been heard. A new product, the CBOE SPXpm (SPXPM), could potentially bridge the “hedge gap” between index products and their respective equities.
First, Why Index Options?
Before getting into the hedge gap conundrum, let's take a look at why index options have become popular hedging instruments. If you hold just one or two stocks, you could certainly hedge with the options on those stocks. Yet, for more complex portfolios, it might make sense to hedge with index options. Here's why:
1—One product for the entire portfolio. If you're truly diversified, chances are your portfolio moves in a similar fashion to a major index—what we call “correlation.” So, trading options in one product (the index) is simpler (and less commission-intensive) than trying to trade options on every security in your portfolio.
2—Size matters. Indices are typically big products. The S&P 500 cash index is currently priced well over $1,000. While this may sound intimidating, because of the product size, you may not need to buy as many options to get the same hedge for your portfolio.
3—Most index options are cash-settled. Cash settlement means easy math. In-the-money equity options settle to the corresponding equity. For example, assume you own the 50-strike put in XYZ stock, and the stock closes at $44 at expiration. If you don't sell the put and you don't have the underlying stock in your account, you will be short stock at $50 per share. To make money, you must then buy the underlying stock for a value lower than $50 per share. And just because the stock closed at $44 on expiration Friday, there's no guarantee you'll be able to buy the stock for less than $50 per share come Monday morning—cash-settled options don't come with this headache. If you're long a 50-strike put in a cash-settled index, and the index settles at $44 at expiration, you get the six bucks (less what you spent on the put, of course). Simple.
4—Broad-based index options can be very liquid. A diversified portfolio will often hold both liquid and illiquid stocks. Trying to hedge individual illiquid stock positions can be costly because you might have to give up a substantial amount through wide bid-ask spreads. Making use of a liquid index to hedge—such as SPX— can potentially alleviate this concern. (Keep in mind, though, that there is no guarantee that a secondary market will be available for any given option contract.)
5—Some of your stocks may not be optionable. Just because a particular stock doesn't have options, doesn't mean you have to live unhedged. Index options might still offer you some measure of protection, even if some of your stocks don't have options associated with them.
The Hedge Gap Conundrum
Often, traders resist using index options to hedge equities. After all, most cash-settled indices settle to an opening print on expiration Friday—otherwise known as “a.m. settlement.” This means that the last day you can trade their options is Thursday. Further, in order to calculate the settlement price of an a.m.-settled index, you need the opening print of every stock in the index. Some stocks invariably open later than others. On a day when the market is moving quickly and some stocks open late, it's possible the settlement price of the index equals a value outside the trading range of the index for that day. Naturally, that's a lot of uncertainty. In theory, your hands would be tied unless you chose to close your trades out early.
CBOE, along with its partner exchange C2, launched the S&P 500 p.m.-Settled Options (symbol SPXPM). Compared to the original flagship SPX product, with SPXpm, options settle with your equities. So you can potentially have a hedge on your equity positions in place until the end of trading on expiration Friday.
You always have the freedom to exit, roll, or otherwise adjust your index option positions earlier than expiration Friday. But, SPXpm options now let you maintain positions through the end of trading on Friday. As you know, many companies tend to release earnings headlines on expiration Friday near the close of business. So of course, protecting yourself should be top of mind. However, because SPX options leave you exposed at the moment at which you may need protection the most, SPXpm options may help resolve the conundrum by filling the gap. (See Figures 1 and 2, below.)
How to Use ’Em
In recent years, we've seen the value of even the most diversified portfolios plunge in response to world events. So, the average investor can feel like nothing can be done to hedge market catastrophes. On the contrary. When diversity can't eliminate risk, again, this is where index options might come in handy. So if you're afraid some shoe will drop in the coming month, and take your portfolio with it, what can you do?
Suppose your portfolio is worth $25,000 and follows the S&P 500 index. You're concerned about a possible drop in the stock market. To hedge, you could buy put options on each of your holdings, assuming three things—that each one of your stocks has options; that you own at least 100 shares of each stock in your portfolio; and that if you own more than 100 shares, you own them in multiples of 100. That's a lot to assume just to hedge a position.
An alternative approach would be to simply buy options in the index—in this case, the S&P 500. And, now that there are SPXpm options, a long put position can potentially protect you even if disaster strikes on expiration Friday.
Protection ’Til the Very End
The beauty of p.m.-settlement is that the index takes its value from the closing prints of each stock. So, at the end of the day on expiration Friday, you'll know exactly which stock value will be used to calculate the settlement price of the index. Yes, it's possible that you could lose your entire investment in the put you purchase. However, you don't have to deal with the possibility of a mid-morning surprise for the value of your hedge. In volatile times, this added protection may be well worth your investment.
Hedging with index options may have advantages over hedging with equity options. While there are certainly the similar risks with S&P 500 index options as there are with the other types of options, what it comes down to is flexibility. And that flexibility has been recently enhanced with the introduction of the SPXpm options. The SPX indices are big-dollar products. But for larger, diversified portfolios, they can help keep commissions low because, when compared to lower-dollar products, it takes fewer options to implement the same hedge.