In this article, we’re going to examine a popular strategy – the “collar.” We feel it’s apropos, since it appears that stocks may have now embarked on the next leg of the bear market. Moreover, we’ll give you our take on how to best utilize the strategy, and we’ll also take a look at a new application with $VIX options that should be of great interest.
As our regular subscribers know, the CBOE recently listed cash-based options on its Volatility Index ($VIX). We have published several recent articles describing the details of these options, so we’ll review those only briefly in this article.
Options have many uses, but a primary one is that they are built to be a hedge for many investors and traders – in order words, to take some uncertainty out of a particular trade or strategy. This is a well-known fact for professional traders, but less so for the novice option trader or – even worse – the investor who doesn’t use options because he considers them to be strictly a speculative vehicle.
The decision to set up a hedge to protect one’s stock portfolio is never an easy one. When times are good and stocks are rising, investors are loathe to spend the money required to hedge their positions. When times are bad, and the market is dropping, the cost of hedging increases. However, that fact is usually understood by investors, who might not mind paying a little more for insurance once it is obvious that stocks are no longer rising, in general. However, another impediment to hedging usually surfaces at that time: an investor fears that he has waited too long, and thus doesn’t want to buy insurance right at the bottom of the market’s decline.
For quite some time now (perhaps since last November), we have been pointing out how the voracious appetite for volatility protection has had the effect of distorting the term structure of the $VIX futures. Recently, though, this activity has branched out in a way that is only rarely seen in the markets: in short, large institutional traders are both buying stocks and buying volatility ETNs (thus, by inference, they are buying $VIX futures). Hedging on a large scale can distort technical indicators and other things – such as the term structure. That is, we can’t really interpret this activity in a contrary manner. Are these traders bullish (because they’re buying stocks) or bearish (because they’re heavily buying protection)? In truth, it’s probably the former, but their need to buy protection also means they’re not overly bullish. This reminds me very much of what was happening in QQQ options at the end of the tech stock craze in 2000.
In this newsletter, over the years we have presented many methods for protecting a portfolio of stocks. Some are “ancient,” such as buying S&P 500 Index ($SPX) puts and some are “new,” such as buying $VIX calls. With the continuation of the bull market well into its fourth year (making it the fifth longest bull market in history – but not the fifth largest), many portfolio managers and individual investors are becoming concerned that a sharp correction may be more than just a remote possibility. As such, the topic of protecting a portfolio with derivatives has once again risen to the forefront. With that in mind, I wrote The Striking Price column in Barron’s this week, on this topic.
