Hedging Portfolio With SPY/SPX/ES Options?

[HappyTrader]

Hello,

Say you have a portfolio that you wish to hedge against a 10% drop that may or may not occur in the next few months.

If the market drops by less than 10% in this time, the hedge pays 0$.
If the market drops by 10% or more in this time, the hedge pays 1,000,000$.

(rough numbers)

Let's say, the S&P 500 is considered an accurate representation of the market, and therefore SPY (ETF), SPX (index) and ES (Future) are considered as underlying instruments to use. With Options on those instruments the ones being planned to purchase.

Let's also say, that a Bear Put Spread is the desired form of hedging. For example:
BUY 2500
SELL 2450

This should result in a debit, no possible loss beyond the debit paid, and a payout structure that meets the requirements.

The question then becomes, which is the best instrument to execute this hedge with?

1) With SPY ETF, the issue becomes that you need a LOT of options (approximately 2000)
2) With SPX/ES fewer options are needed.
3) I suspect (even with IB commissions), the commissions for SPY Options would be greater than SPX/ES options.
4) I heard (I have no experience with futures trading) that the spread on SPY ETF is tighter than SPX/ES (therefore getting you a better price)?

Let's further say:
1) There is no interest in the different tax savings (let's take that out of the equation)
2) There is no interest in margin/leverage benefits (the only interest in SPX/ES would be the 'value' of the contract for purpose of purchasing fewer quantity).

What would be the normal or preferred mechanism for handling this hedge? SPY Options, SPX Options, ES Options, or something else entirely?

Thank you.

 

[tommcginnis]

One quick observation:
The ES equivalent will cost you roughly twice in commissions, as it carries a 50 multiplier, rather than the SPX's 100.

A second observation:
The ES is a CFTC beastie, which carries SPAN margining, which can be a ROYAL p.i.t.a. ,
The SPX options are an SEC thang, which means margin control is easier to figure. (Unless your own broker makes it a p.i.t.a. "Ahem. IB.")

Third observation: the ES FOPs are traded pretty well outside of primary cash hours -- the SPX became more broadly traded some months back (a *year* ago?!?) but it's fiction. If news-related timing may be a factor in your position, it may be worth the commission effect to have an active pre-market trade available.

 

[HappyTrader]

1) So from a commissions perspective, SPX is better than ES due to the multiplier.

2) How bad can margin control be, if the plan is a debit spread (in theory, everything paid up front). Will the broker make additional margin problems/calls?! Or will it just 'calculate' a maintenance margin that will be annoying but not have any other real effect (other than of course, it impacts your margin if that is a concern).

In a 'non-leveraged' account that has, for example, 1M, all equities, nothing on margin, then this margin issue due to SPX or ES options should be effectively a non-issue right? (Or am I totally missing something here)

3) Let's say there is no timing interest or news interest. Pure simple hedge for prolonged market moves, more than happy to 'miss' a fast dip and even close the position the next day.

Based on this it would SEEM that SPX is the winner?

Out of curiosity, what would an institution use? (or would they do a combination of ES/SPX and completely skip over SPY) ?

Thank you again.

 

[tommcginnis]

1) So from a commissions perspective, SPX is better than ES due to the multiplier.

Not just the multiplier, but exchange fees/broker commissions, as well. On IB, SPX is roughly 1.31¢, while the ES runs ~1.62¢. [so it's actually another 24% more. If you're piling $1k in commissions a week, it matters. If your commissions are $100-$250, it's a pizza.]

2) How bad can margin control be, if the plan is a debit spread (in theory, everything paid up front). Will the broker make additional margin problems/calls?! Or will it just 'calculate' a maintenance margin that will be annoying but not have any other real effect (other than of course, it impacts your margin if that is a concern).
In a 'non-leveraged' account that has, for example, 1M, all equities, nothing on margin, then this margin issue due to SPX or ES options should be effectively a non-issue right? (Or am I totally missing something here)

Ohhhhh, you'd THINK it'd be a non-issue, but do an ET search for IB and/or margin within the last month or two, and you'll see a couple of *ridiculous* threads: IB, in following an *admirable* goal of fiduciary conservatism, has found the line-of-reasonableness, and seemingly leapt *right*over* it. {confession: I am a 10+-year user/fan/toady of Interactive Brokers. That don't mean I'm blind, though. This is our living, after all.}

3) Let's say there is no timing interest or news interest. Pure simple hedge for prolonged market moves, more than happy to 'miss' a fast dip and even close the position the next day.
Based on this it would SEEM that SPX is the winner?

If not a clear winner, certainly a healthy, hefty Straw Man.

4) Out of curiosity, what would an institution use? (or would they do a combination of ES/SPX and completely skip over SPY) ?

I don't have direct knowledge of that, but SPX options trade roughly 4x the ES volume each day; SPX open interest is ~2x that of the ES. Whether that's retail, quasi-retail, or deep-dollar-"It'll-take-me-2-days-to-get-out-of-this-position" traders -- don't know.

 

[iprome]

Third observation: the ES FOPs are traded pretty well outside of primary cash hours -- the SPX became more broadly traded some months back (a *year* ago?!?) but it's fiction. If news-related timing may be a factor in your position, it may be worth the commission effect to have an active pre-market trade available.

Hi tommcginnis, if the instruments in OP's existing positions are only traded within regular hours, will the use of futures or FOPs (as a hedge) introduce unwanted over-hedging effect or margin consequences during night hours?

 

[tommcginnis]

Hi tommcginnis, if the instruments in OP's existing positions are only traded within regular hours, will the use of futures or FOPs (as a hedge) introduce unwanted over-hedging effect or margin consequences during night hours?

1) I don't know.
2) A VERY interesting question. (I mean, from all that's gone on lately, 'it could!')