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)

Source: Bloomberg

Implementing put spreads

Many investors are familiar with put options, an option contract to sell a specified amount of an underlying security at a defined price within a set time frame. A put spread is a tactical-overlay hedge that provides limited downside protection, but at a lower cost than purchasing an outright put. As shown in Exhibit 2, an investor creates a put spread by purchasing an ATM put and selling a 90% put, which is 10% out of the money. The chart shows how this approach significantly reduces the hedge cost—the net premium paid—by taking advantage of selling the put that trades at a significantly higher volatility. 
For reference current pricing on a put spread that includes an S&P 500 one-year 100% (ATM) put option and subtracts a 90% put option is historically attractive, at a net cost of approximately 2.5%. Compare against a one-year ATM put option, at a cost of approximately 5.10%, and you’ll see how significant the savings can be.

Exhibit 2: Example put spread and put as an equity hedge

Source: Bloomberg

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)

Source: Morgan Stanley Quantitative and Derivative Strategies as of 8/29/2018

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.