So it happened. Finally. The Correction.
Now this post clearly comes after the fact, but I wanted to discuss the ways in which you can hedge your portfolio against price movements as well as volatility. There have been strategies discussed here, but I first want to bring you some insight from other option traders.
This strategy comes from Larry McMillan, via Steve Sears over at Barron's:
McMillan is advising clients to hedge against a decline by buying six Chicago Board Options Exchange Market Volatility Index (VIX) February $22.50 calls. The VIX, the market's so-called fear index, should gain value as the market declines.
To temper the hedge a bit, McMillan suggests buying four February $108 calls of the S&P 500 ETF, known by its ticker, SPY.
Now that's a tricky bet, and is probably not suited for most. Here's why:
Buying VIX options requires a level of complexity that most traders don't need-- these trades should be suited for your individual portfolio. Remember, VIX options are not related to the actual spot VIX-- rather, they are tied to VIX futures, which may or may not be near the VIX price. So when the VIX spikes and you wonder why your Feb Calls didn't run as far as you had hoped, that's why.
Also, what is this trade tryinig to accomplish. The VIX calls effectively get you long volatility in the market, and the call buy hedge gives you some positive delta and gamma along the way.
Remember the context-- McMillan manages money through a lot of covered calls-- that means he's short vega and gamma (the acceleration), and odds are the portfolio is large enough to warrant the use of VIX calls.
But for smaller portfolios, it costs less in overall basis and commissions to just purchase SPY puts, assuming that your book is net short gamma. This protects your downside as well as the volatility risk.
Of course, if you're running a stock only portfolio or you have a lot of option buys to begin with, you may want to consider call vertical outlays-- where you short SPY call spreads for a credit-- if the market takes off, your upside risk is capped and you should make it back from your preexisting positions.