I want to hedge my portfolio with S&P500 options and have been looking into it quite a bit, but have some unanswered questions I'm hoping people here are knowledgeable enough to answer for me: 1.) Is the S&P500 regular dividend adjusted (not just special dividends)? If not, obviously I'd need to take that into account for the hedging. I've looked and I've found conflicting information. I know it is adjusted for special/surprise dividends, but what about standard/expected dividends? 2.) When using Black-Scholes to calculate the implied volatility for hedging is there any consensus on which option's implied volatility is best to use? Should I use the implied volatility from the option I will be using to hedge or should I do an average of implied volatilities or even use the VIX? Furthermore, if I just want to hedge for only a day would it make sense to use the implied volatility from an option with a closer expiration date that is at the money so that the implied volatility is less affected by the volatility smile? Thoughts? Thanks in advance.
1. I presume you are asking whether options are adjusted for regular dividends. No, they are not, however dividends are priced into the options so I'm not sure what your dilemma is. 2. Implied volatility is by definition the volatlity that is implied in the current market option prices, so for a particular option there can only be one implied volatility. You haven't mentioned how you are planning on hedging your portfolio? Long puts? Delta hedging? Why are you so hung up on using the implied volatility to hedge your portfolio? To make the long story short, you may want to rephrase/clarify what is it exactly you want to do and what kind of a portfolio it is, as you seem to be throwing some terms around, yet have no idea what they really mean.
Thanks for the response, and sorry for being unclear. Let me clarify: 1.) I'm trying to ask whether the S&P500 is adjusted for regular dividends because (you're right) I am trying to delta hedge. I know that because options take the dividend into account, when trying to calculate the implied volatility one must reverse this by again taking the dividend into account. For indices, I've read because they are composed of so many stocks, it's like having a continuous dividend yield, so the way to deal with an index's constituent dividends is to subtract the dividend yield from the risk free rate when finding the implied volatility. 2.) Yes, I'm trying to delta hedge. While there is only one implied volatility per option, there are many options on the same underlying security with the same expiration date, albeit different strike prices. Theoretically, the implied volatilities calculated from this set of options should be the same because the underlying security is the same and thus the underlying volatilities calculated from these options should be the same. However, in actuality, they aren't the same and this phenomenon has the term "volatility smile," I believe. My problem is that I don't know which option to use to calculate the implied volatility since different options give different volatilities. If I had to guess which option to calculate the implied volatility from I would think perhaps the best strategy would be to average the implied volatilities calculated from the most at the money call and put options as the volatility smirk is less bad at the money. Hopefully that's clear. Thoughts?
1. Not sure what you mean whether S&P 500 is adjusted for dividends? You are correct though, when using an option pricing model you generally use a continous dividend yield. 2. Ok, it is more clear now, but still, why do you need a single implied volatility number? If you are delta hedging then just use the implied volatility of the option you are using to hedge.
Options are not adjusted for regular dividends - they are priced into the options. But what difference does it make? And why all the gyrations to determine a dividend adjusted implied volatility? If you're going to delta hedge, you're interested in the delta of the options that you are using. Yes, change in IV results in change in delta but you're considering delta hedging not IV hedging. And FWIW, I've never heard of IV hedging. I may very well be tiotally uninformed. But I can't imagine rebalancing a portfolio hedge every time IV fluctuates up or down. AFAIK, you have bigger issues to deal with than dividends and assorted tangential and irrelevant issues such as average IV, IV smile, the VIX, etc.. Does your portfolio correlate best with the S&P 500? How well do you want to be protected? Cost is directly proportional to protection level so what's your balance of premium versus deductible going to be? What's your time frame? Etc.
I am with spin on this one. Forget the dividend and the fluctuations in the IV or the shape of the skew in the IV curve. You need to figure out your correlation to the SnP500 first and foremost. After that, youâre a market taker not a market maker so you could come up with any fair value you like for the particular options youâre looking at but thatâs not going to change the price in the market place. The only thing in that respect you need be concerned about is that youâre consistent in the variables you use. Donât end up changing your set constantly to fit the markets. Figure your correlation and then stick with those variables in the options you choose (time aside) unless they get very far out of line with the market. If not, youâll never have a consistent read on where you stand hedge wise to your portfolioâs delta. In other words donât rehedge the delta constantly.
I agree with most of what as been said, your main concern should be making sure of your correlation...though you may want to check an alternative to buying puts. If you fear a rise in volatility, take a look at this: http://www.cboe.com/micro/vix/VIXFuturesOptionsUMass2pgJuly2009.pdf and http://www.cboe.com/micro/vix/VIXFuturesOptionsUMass43pgJuly2009.pdf IMO its a good alternative to buying puts and its cheaper too...
If I was an investor rather than a trader, I'd look at collaring my portfolio... Sell some OTM index calls to fund the purchase of some OTM puts. Use other people's money to achieve low cost/free catastrophic protection. And if wrong, you have a nice gain on your portfolio to offset lower delta OTM puts, if they come into play.
I don't really like collars because puts are more expensive than calls so you limit your upside alot if you want to have a "reasonable" price on the short call. It depends on your market view I guess but IMO to do a collar you have to be fairly sure its not gonna go up a lot in the meantime.
Your comments are correct. But in the context of this discussion, the nominal amount that puts exceed calls in time premium isn't significant because the objective is hedging one's portfolio. Regarding limiting the upside, with a collar, that's what you give up in return for a low/no cost hedge in an uncertain environment. And the upside is not a problem because if your correlation is good, you have 100 delta underlying offsetting a lower delta call loss up to that OTM call strike. Above that, it's basically a wash. In the end, you are absolutely correct. A collar is only viable if the benefits and trade offs are within your comfort zone.