By Derek Moore
This week ZEGA’s traders began to strategically perform some early rolling of long options that due to the run-up in the market became very sensitive to changes in the underlying index (S&P 500 Index). As many of you know, hedging is our main business and we look to be focused in protecting not only the downside but also protecting gains when they become so outsized.
This is a good thing! It means you and your clients in our Buy and Hedge Strategy have realized a good amount appreciation and in some cases more, of the market’s impressive start to the decade. This is one of several tactics at our disposal.
Reducing Downside Participation and Protecting Gains
First, let’s explain how calls have an increased risk of downside giveback of their gains. When those positions were bought, they typically will have a Delta of around 55-65%. For example, purposed, let us use 55%. This means that for the next 1 point up move in the underlying S&P 500 Index, they would capture 55% of that move. It also means that if the S&P 500 Index were to move lower by 1%, they would only suffer 55% of that move.
Deltas on calls move higher as the underlying goes up or moves further and further in the money. Those calls were sitting around an 85% to 100% Delta. Now you might say, that sounds great since we can grab 90% of the next 1 point higher. But, remember it works both ways. It would also mean that it would lose 90 cents for every point the S&P 500 drops. It’s a double-edged sword. As this is a predominantly protective strategy, we don’t like having exposure to lose 90 cents on every dollar drop.
We solve this problem of exposure by doing what is known as rolling the calls. Rolling to a further out expiration will reduce the delta exposure and reduces downside participation. This is also consistent with our portfolio delta targets, and upside market capture, of around 70% - 75% of upside moves while reducing participation in the downside by instituting downside limits.
Locking in Gains
This move essentially locks in unrealized gains, makes them realized for the portfolio, and rehedges at the same time.. It is also a more conservative decision given that there are several binary market events in the coming months including the interest rate decision of the Federal Reserve and inflation data. Since we are swapping out a higher delta option to a lower delta option, any market retracement would give back less than had we kept the current option positions.
Due to these being the September expirations (and in some cases December), any material downturn would give up quite a bit of the gain with little time to consolidate and move back up. Plus, once a market turns lower and call options are less in the money, the return higher to its current value would have to do so starting at a lower delta. Simply put, on recovery, the rate of change in the premium based on market movements would be lower and it is unlikely there will be enough time to do so.
Laddered Expirations Where Possible
Finally, the third main point we’ll be discussing is that of expiration risk. Depending on the size of the portfolio within Buy and Hedge Retirement, ZEGA’s traders may look to spread out the expiration dates by instituting several tranches of call options that expire in a staggered fashion.
We call that laddering the expiration dates. While this may or may not impact your portfolio, doing so does create some flexibility on future adjustments. It also allows us to roll calls more often locking in gains and raising downside limits.
So to sum up, we are reducing the “give back” risk on unrealized profits in the strategy given the market run-up. Again, this is a positive. Our tactics here reset the strategy to better align with the objectives we often talk about. If the market were to materially turn downward or a sudden bear market, Buy and Hedge has built-in floors below the market that provide meaningful protection.