Many traders know that options strategies provide an abundance of choices and can sometimes be quite intimidating. But is it possible to construct an options trading strategy that will hedge against bad news-whether expected or unexpected? The answer is yes and no. Today provide some guidelines for those that wish to explore this concept further.
Known events or unknown events -
In the markets as in life, there are often "known unknowns" and "unknown unknowns." Sometimes, we know when an event is going to occur; we just don't know what the result will be. Examples of these "known unknowns" could be earnings reports, economic reports, or even election results.
Other times, we don't know what will occur, when it will occur, or even if it will occur. These unknown unknowns are sometimes called "Black Swan Events," and they include things like merger and acquisition announcements, terrorist attacks, or natural disasters.
So when can you hedge?
We cannot hedge against unknown unknowns, as it would be totally cost prohibitive to maintain a constant state of hedging against all possible adverse events, with uncertain outcomes that may or may not ever occur.
We can hedge against known unknowns in a cost effective manner by selecting the appropriate strategy and an expiration date that falls after the particular event. So let's focus on hedging known unknowns.
Setting up a hedge:
The first step in hedging against a known unknown is to determine when the event will occur. The dates of the known unknowns, listed above (and many others) can typically be found on any reputable financial website, or inside your web trading platform.
The second step in hedging against a known unknown is to determine what you are trying to hedge against. Most of the time it is a sharp price decline, but it could also be a sharp price spike (if you have a short stock position), or even a volatility spike (if you have a short option position). These known unknowns typically impact price, or volatility in the following ways:
- Large price swings in either direction are quite common immediately following earnings announcements.
- Volatility usually begins to ramp up about one week before earnings, peaking just before the announcement, and can sometimes hit three to four times normal levels.
- Volatility usually drops sharply immediately following the announcement.
- Broad equity price swings are possible immediately following the announcement if the report misses the estimates. The direction of the move is hard to determine and it may not always make sense.
- Volatility tends to lessen immediately before major announcements.
- Volatility may pick up modestly, immediately after the announcement, unless the report is close to the estimates.
- Market response varies greatly and has historically been inconclusive with regard to election specifics (i.e., political party, first or second term, incumbent or challenger).
- Volatility tends to lessen modestly before results are announced.
- Volatility may increase modestly following results due to future uncertainties.
Once you have determined what you are trying to hedge against, you need to select the most appropriate option strategy. Here are some guidelines to keep in mind:
- In the marketplace, volatility tends to drop when equity prices rise and rise when equity prices drop, all else being equal.
- Volatility manifests itself in the time value of an option price. Since the intrinsic value (if any) is based entirely on the price of the underlying stock, only time value changes when volatility changes.
- ETFs, ETNs and options that are seemingly tied directly to volatility and/or the VIX may not provide adequate protection except during times of extreme volatility spikes. Traditional option strategies on specific stocks are typically a better choice than broad market volatility-related products.
- Spreads, collars and other strategies that involve an equal number of long and short options, tend to neutralize much of the impact of volatility changes, so the focus is mostly on price change.
- Long options generally work in your favor when volatility increases, while short options generally work against you.
- Strategies involving long options, or more long options than short options, will generally benefit from an increase in volatility.
- Strategies involving short options, or more short options than long options, will generally benefit from a drop in volatility.