Using Options as a Hedging Strategy

Mark Patterson MHP Asset Management

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Expert: Mark Patterson
MHP Asset Management

New Hampshire & Portland, Maine

Using Options as a Hedging Strategy

hedging with options

Option contracts represent 100 shares of company stock, Exchange traded funds, or even commodity futures may have these options contracts available. There is a volatility index known as the “VIX”, that increases in value when there is volatility in the equity markets and decreases when there is complacency. Post-election the “VIX” has gone very low in a time with much uncertainty.

Hedging is very common among the “smart money” who are thought to be the institutional investors. Examples of Institutional investors would be a mutual fund, a large pension plan or maybe an insurance company. These institutional investors use option contracts as a means of hedging and income. Most of the speculation in the options market is done by retail speculators, or what Wall Street likes to refer to as the “dumb money”. Speculation and hedging are very different.

There is no reason why we can’t manage our assets the same as the institutions. However there is a strategy that mirrors the purchase of the VIX calls but has an income component and does not rely on time to expiration like the VIX options. I prefer to build a position in the exchange traded fund “VXX” which is an ETF that does not have an expiration like the options contract “VIX”. Instead of just purchasing this ETF outright, I prefer to sell cash covered puts (options contracts) and collect the premium for our accounts. We may then get the VXX put to us at the strike price that we sold. That’s OK because we want to build a position in the VXX. If the put that we sold expires worthless to the buyer of the put that we sold, then we just keep the income that was the premium they paid.

There are two elements they must be aware of and buying selling an option contract. One element is time the other is intrinsic value. If you are buying an option contract the time value decays until expiration. However, if you are option seller you have collected premium and you want the time to decay in order to keep premium that the buyer of the contract has paid you. The intrinsic value represents the underlying investment value which can go up, down or stay the same.

I realize that this may sound confusing if you do not do this on a regular basis, but all you need to realize is that VXX is very low and that volatility will very likely return to the equity markets. Why not take advantage of what you could view as an undervalued ETF that may rebound in the future?

If you have an interest in these portfolio management techniques, you can contact my office and I will be happy to give you information regarding these options strategies.

Options carry risk, do not use them if you’re not sure what you are doing and have a very good understanding of these derivatives and their leverage.

Mark Patterson is Chief investment officer with MHP Asset Management and can be reached at (603) 447-1979 or mark@mhp-asset.com

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