We recently outlined four different shorting strategies (see that November commentary). Today, we share another way to hedge with options that meets two key criteria for long-term investors who want a market hedge in place: This hedge can be sizable, because your risk is capped, and it can be long term in nature, or used repeatedly.
Double Bear Spreads
Consisting of two bear spreads with the same expiration date, a double bear spread is also called a Combination Bear Spread or, amusingly, a Bear Spread Spread.
The strategy involves setting up both a bear call spread (selling a call and buying a higher-strike call to cap the risk), and a bear put spread (buying a put and selling a lower-strike put to finance part of the cost). Let’s illustrate.*
On the S&P 500 Composite, using CBOE SPX options (a bit more on that in a moment), and let’s assume that the S&P 500 is right around 4,500, an investor seeking a hedge could initiate the following options, using an expiration a few months to several months ahead (for this example, we looked at options that expired in 86 days):
Each contract represents 100 times exposure, so the puts you purchase (the most relevant option in this hedge) each represent a nominal value of $425,000. For someone with a portfolio of $1 million, a single contract would offer nominal protection of 42.5% of their assets starting at the strike price. (If an investor would prefer less exposure, they can consider CBOE Mini SPX options, each of which are one-tenth the value.)
The focal position here are those purchased puts: The investor wants to own enough puts to provide meaningful downside protection without having to pay much for it. For each put purchased, you multiply the strike price by the option multiplier (100 in this case) to get the notional dollar value of exposure. So, what do the three other options do?
The calls that are sold to open at a strike of 4,750 pay for a good portion of the cost of the 4,250 puts (in this case, about 70%). But you’re not done yet. One could also sell to open the 3,750 puts for more proceeds (due partly to high demand, SPX puts can pay well). Those puts should be sold at a strike price where the person hedging would be happy to see the spread’s protection become fully realized. In this case, the S&P 500 could fall 16.6% before reaching the 3,750 put strike price—a large decline for the index—where profits are maximized.
The sold put proceeds are enough to also buy protective “you never know” calls, in case the S&P 500 goes on a mad rally. One generally doesn’t want large nominal short exposure (through the short 4,735 calls, in this case) without protection to the upside. The calls purchased in this spread limit the total risk on this short to a maximum window of a 4.5% gain in the index (the difference between the 4,735 and 4,950 calls). From its recent level around 4,500, the S&P 500 would require a 10% gain to reach that top strike price, or the max loss. It’s always surprising to see the S&P 500 rise that much in a few months, but the point is you never know, and one wants to be ready for anything.
With the S&P 500 around the 4,500 level when this example was created, while knowing we had 86 days to expiration at the time, below are the market moves we have to see before our strikes are reached:
Whichever direction the market goes, the whole position will initially work for or against the investor to varying but predictable degrees. With a combined starting delta of about 0.4, the prices would move about 40% of the underlying market’s move. The change in magnitude, or the options’ delta, would grow the more the market moved in one direction. And, of course, all the options lose time value day by day (offset modestly at times by increases in implied volatility).
Even though this position does help an investor early on even when the market falls only modestly, it’s not very relevant until the market falls more meaningfully. What one aims for most here is protection for a market decline of greater than 5% or so, and one really wants protection from a “panic” 7%-15% decline. As you can see above, at no cost to set up, this position provides that: Roughly 6% to 17% lower is this position’s sweet spot where the hedge pays off best; 16.6% lower would see it achieve its max profit.
Given that one can set these up without cost, and the main risk—though it is a real one—is a loss on this position for a span of prices well above recent S&P 500 prices, one could comfortably make the position sizable. If this hedge was a 35% allocation (offsetting 35% of one’s long exposure), the max loss if realized would equate to about a 1.6% drag on the portfolio, if the S&P rises 10%. Ideally, if the S&P rises 10% to cause this, the long positions have risen more than enough to cover this drag and more. And, risking a low-probability max cost of 1.6% for meaningful potential downside protection seems reasonable.
Now, you may be wondering, “Why a time frame of only a few months, and why only a 5% or larger drop by expiration?”
With options, in our view, you usually need to target a 5% decline or larger. The cost and trading dynamics of options, even if you finance them with other options, often makes targeting small declines impractical, even though early on this position will help on any decline at all. Secondly, historically most large drops in the S&P 500 happen in just four months or less. Hence, we usually want to target expirations within that time frame with this strategy. Why sit on short exposure for longer periods when most drops happen quickly, and we can keep setting up this type of position instead?
Below is a scatterplot of all the S&P 500’s declines of between 10% and 20% since the composite grew to 500 companies in 1957.
The strategy involves setting up both a bear call spread (selling a call and buying a higher-strike call to cap the risk), and a bear put spread (buying a put and selling a lower-strike put to finance part of the cost). Let’s illustrate.*
On the S&P 500 Composite, using CBOE SPX options (a bit more on that in a moment), and let’s assume that the S&P 500 is right around 4,500, an investor seeking a hedge could initiate the following options, using an expiration a few months to several months ahead (for this example, we looked at options that expired in 86 days):
Each contract represents 100 times exposure, so the puts you purchase (the most relevant option in this hedge) each represent a nominal value of $425,000. For someone with a portfolio of $1 million, a single contract would offer nominal protection of 42.5% of their assets starting at the strike price. (If an investor would prefer less exposure, they can consider CBOE Mini SPX options, each of which are one-tenth the value.)
The focal position here are those purchased puts: The investor wants to own enough puts to provide meaningful downside protection without having to pay much for it. For each put purchased, you multiply the strike price by the option multiplier (100 in this case) to get the notional dollar value of exposure. So, what do the three other options do?
The calls that are sold to open at a strike of 4,750 pay for a good portion of the cost of the 4,250 puts (in this case, about 70%). But you’re not done yet. One could also sell to open the 3,750 puts for more proceeds (due partly to high demand, SPX puts can pay well). Those puts should be sold at a strike price where the person hedging would be happy to see the spread’s protection become fully realized. In this case, the S&P 500 could fall 16.6% before reaching the 3,750 put strike price – a large decline for the index – where profits are maximized.
The sold put proceeds are enough to also buy protective “you never know” calls, in case the S&P 500 goes on a mad rally. One generally doesn’t want large nominal short exposure (through the short 4,735 calls, in this case) without protection to the upside. The calls purchased in this spread limit the total risk on this short to a maximum window of a 4.5% gain in the index (the difference between the 4,735 and 4,950 calls). From its recent level around 4,500, the S&P 500 would require a 10% gain to reach that top strike price, or the max loss. It’s always surprising to see the S&P 500 rise that much in a few months, but the point is you never know, and one wants to be ready for anything.
With the S&P 500 around the 4,500 level when this example was created, while knowing we had 86 days to expiration at the time, below are the market moves we have to see before our strikes are reached:
Whichever direction the market goes, the whole position will initially work for or against the investor to varying but predictable degrees. With a combined starting delta of about 0.4, the prices would move about 40% of the underlying market’s move. The change in magnitude, or the options’ delta, would grow the more the market moved in one direction. And, of course, all the options lose time value day by day (offset modestly at times by increases in implied volatility).
Even though this position does help an investor early on even when the market falls only modestly, it’s not very relevant until the market falls more meaningfully. What one aims for most here is protection for a market decline of greater than 5% or so, and one really wants protection from a “panic” 7%-15% decline. As you can see above, at no cost to set up, this position provides that: Roughly 6% to 17% lower is this position’s sweet spot where the hedge pays off best; 16.6% lower would see it achieve its max profit.
Given that one can set these up without cost, and the main risk—though it is a real one—is a loss on this position for a span of prices well above recent S&P 500 prices, one could comfortably make the position sizable. If this hedge was a 35% allocation (offsetting 35% of one’s long exposure), the max loss if realized would equate to about a 1.6% drag on the portfolio, if the S&P rises 10%. Ideally, if the S&P rises 10% to cause this, the long positions have risen more than enough to cover this drag and more. And, risking a low-probability max cost of 1.6% for meaningful potential downside protection seems reasonable.
Now, you may be wondering, “Why a time frame of only a few months, and why only a 5% or larger drop by expiration?”
With options, in our view, you usually need to target a 5% decline or larger. The cost and trading dynamics of options, even if you finance them with other options, often makes targeting small declines impractical, even though early on this position will help on any decline at all. Secondly, historically most large drops in the S&P 500 happen in just four months or less. Hence, we usually want to target expirations within that time frame with this strategy. Why sit on short exposure for longer periods when most drops happen quickly, and we can keep setting up this type of position instead?
Below is a scatterplot of all the S&P 500’s declines of between 10% and 20% since the composite grew to 500 companies in 1957.
Source: Bloomberg and 1623 Capital calculations, taken since the S&P 500’s inception in 1957, and showing a scatterplot of all 10% to 20% declines top to bottom. As of January 2024.
As you can see, a majority (19 out of 26) of these declines took place over four months or less, and many happened in two months or less (about 12).
Finally, returning to the options discussed here: We focused on CBOE SPX options with this strategy for a few reasons. Obviously, they’re liquid and large, and using them saves on commissions because you can trade many fewer contracts for greater value. But there are also mini SPX options that represent one-tenth the size of these regular ones. The 4,250 mini SPX put is $42,500 of nominal exposure rather than the $425,000 regular put we outlined here. There are also “nanos” that are one-hundredth the size (so, $4,250 in this example).
Second, SPX options can only be exercised at expiration, not before, so that provides an investor with more certainty and control. Third, SPX options are cash-settled. The underlying vehicle never comes into play. So, if you keep an in-the-money SPX option open at expiration, it’ll be a cash transaction, not shares. Fourth, SPX options can get favorable tax treatment, with up to 60% of the realized gains or losses always being treated as long-term for capital gains purposes, even if the trade duration is short term. That can make a sizable difference for anybody when tax time comes.
We’re not tax advisors and we’re not giving tax advice, but if you’re trading options on the SPDR S&P 500 (NYSE: SPY) ETF, either as a hedge or for income or upside, SPX options could be attractive for you instead, given all these attributes.
Finally, do realize that when the S&P 500 rises above your short call’s strike by expiration (the 4,735 call in this case), you’d be sitting on a loss. You’ll need to absorb that loss, and as this hedge will be expiring, you’d need to set up a new hedge if you want to keep hedging. So, if the market enters a period where it climbs quarter after quarter, this hedge could become a steady drag on your results. However, since one typically sets this strategy up about 5% out-of-the money (above current market prices) each time, the drag on results will ideally be small, unless the market is rising much more than 5% by each expiration, and then ideally the rest of the portfolio is, too.
We hope you enjoyed this commentary on another market hedging strategy we’ve used.
—Jeff Fischer, Chief Investment Officer
*Information presented about the double bear spread is for educational purposes only and does not represent any real or actual results. While certain real data points may have been used, their assumptions and results are illustrative in nature.