Reducing U.S. equity risk by hedging with a put spread
Since February’s “Vixplosion,” with volatility more than doubling over the course of several days, equity market volatility has meandered lower. Most U.S. equity markets have climbed a wall of worry back to all-time highs. But we are still late in the bull-market. And if you share Russell Investments’ house view that U.S. equities are more overvalued than many international developed and emerging markets, it may be a prudent time to consider adding some protection to help reduce downside risk.
Right now, we see a combination of low volatility levels and high put skew. We believe this environment provides a significant downside-protection hedging opportunity, in the form of a put spread.
What is put skew?
Exhibit 1 shows our current environment in context, with relatively low volatility and high put skew. The three lines represent current day, the market sell-off from earlier this year, and March 9, 2009 (when the S&P 500 bottomed during the Global Financial Crisis). This is commonly known as the volatility skew which portrays the relationship of volatility levels of at-the-money (ATM) put options versus put options further away from the money. Persistent demand for purchasing put tail-risk insurance results in significantly higher implied volatility further out-of-the-money.
Exhibit 1: U.S. Equity option volatility relative to strike price
(S&P 500 Index 1-year option pricing, as of August 29, 2018)
Implementing put spreads
Exhibit 2: Example put spread and put as an equity hedge
The power of asymmetry
The asymmetry of volatility pricing with the ATM put option pricing at a 14% vol and the 90% put pricing at 18% vol not only lowers the cost of the put spread, but may also help improve the probability of success. Per Exhibit 3, S&P 500 one-year 90-100% downside skew is exceptionally attractive at the 99th percentile versus the last 15 years. Purchasing the ATM put option at low volatility levels also improves the attractiveness of this spread, with current one-year implied volatility levels trading at historically attractive levels in the 12th percentile. To be clear, buy low and sell high applies here, too. It is good to sell put skew when it is at the upper end of historical percentile pricing and buy volatility when it is at the lower end of historical percentile pricing.
Exhibit 3: S&P 500 Key volatility and option skew characteristics (15-year history)
If you are more interested in hedging a market that has been outperforming in the recent run-up, a NASDAQ 100 or Russell 2000 put spread could provide attractive protection as well. These two indexes are often higher beta, but come at slightly higher premiums.
With current volatility levels low and put skew high, hedging a portfolio with a put spread may offer an attractive risk reward opportunity and can be helpful additions to your toolkit in managing portfolio downside risk. Consider working with a solutions provider experienced both in implementing hedging strategies and in monitoring market environments.