Hedging w/ Futures & Options: Bullish, Bearish & Neutral Strategies

As you know, we're in the third year of the presidential cycle, which on a historical basis has been quite bullish for the markets.

1. The DJIA has risen 24 times and fallen 5 times in the 29 third calendar year of the Presidential Cycle since 1891.
   
   
2. The overall, average gain for the 29 third calendar years is 12.31%, with the 16 Republican presidencies averaging gains of 5.12% and the 13 Democratic presidencies averaging gains of 21.14%. (Source: Stock Traders Almanac)
   

So far confirmed, there will be 196 companies reporting in July and about 30 in August. For the options and futures spreads mentioned below I've chosen an August expiry so we can benefit from the full swing of July earnings report and not suffer from time decay.

Lastly, to keep things simple, each spread below is calculated with the assumption of just 1 contract, options and futures. (Source of prices: CBOE & symbols: Y! Finance)

Hedging w/ Futures & Options: Bullish, Bearish & Neutral Strategies

• 1) Buy CBOE Volatility Index (VIX). Why? On February 27, 07, the VIX experienced the biggest ever 1-day move in % terms in its 17-year price history, as the VIX rose by 64% in one day to close at 18.31 and the S&P closed down -3.5%. Over the 17-year period from 90 through 06, the spot VIX price changes have had negative correlations with the S&P 500 in terms of daily returns (-0.66) and monthly returns (-0.61).

• 2) Reverse Calendar Spread: One would buy a short-term future and sell a long-term future (bearish strategy).
  
  
• Trade Rationale: RCS would be used primarily when one is expecting a bullish market trend to deteriorate into a bearish trend. We would be looking for the longer-term contracts and the near-term contracts to converge in price, something that would happen if the VIX Index rose quickly and the futures contracts did not follow.

Current: VIX 13.34. Buy Aug07 VIX Futures: 14.79 | Sell May08 VIX Futures: 15.5 | Credit of= 0.71

If we had done a similar strategy prior to Feb 2007, we would have covered some of the long portfolio loss.

Historical example: VIX: Feb 15, 07 vs. March 2nd, 2007

• Feb- VIX 10.22 (close to historic low). Buy May07 VIX futures: 13.39 | Sell Nov07 VIX futures: 15.08 | Credit= 1.69
  
  
• March- VIX 19.63 (fastest rise). May07 VIX futures: 14.93 | Nov07 VIX futures: 15.03 | Spread narrowing: 1.59, resulting in profit of 1,590 per contract and successful hedge against market downfall.

• 3) Bear Call Spread: Purchase of an ATM or OTM call option on the underlying asset while simultaneously writing an ITM call option on the same underlying asset with the same expiration month (bearish to neutral).
  
  
• Trade Rationale: If the underlying instrument fails to drop beyond the strike price of the out of the money short call option, the profit yield will be greater than just buying put options. Able to profit even when the underlying asset remains completely stagnant.

Buy to open 151 August SPY call (SYHHU.X for $4.8) and Sell to open 148 August SPY call (SFBHR.X for $6.9)

Maximum Reward= $6.9-$4.8= $2.1
Maximum Risk= Difference in Strike - Net Credit = 3-2.1= 0.9
Break Even= Lower Strike + Net credit = 148 + 2.1 = 150.1

• Disadvantage: There will be no more profits possible if the underlying asset drops beyond the strike price of the short call option.

• 4) Bull Call Spread: Purchase of an ATM or ITM call option on the underlying asset while simultaneously writing an OTM call option on the same underlying asset with the same expiration month (bullish to neutral).
  
  
• Trade Rationale: When one is confident in a rise in the underlying instrument but is also worried that profits may be low if the stock should rise only very moderately or remain stagnant for an extended period of time. It is also a way of buying call options at a discount by selling the out of the money call option at a strike price beyond that which the underlying instrument is expected to rise.

Buy to open 151 August SPY Call (SYHHU.X for $4.8) and Sell to open 157 August SPY call (SYHHA.X for 1.99)

Maximum Return = [(Difference in strikes - Net Debit) / Net Debit]
[(157-151 - (2.81)] - 2.81
-) 3.19-2.81= 0.38 x 100= 38%

Maximum Risk = Net Debit = 2.81 | Break Even = Lower Strike + Net Debit = 151 + 2.81= 153.81

• Disadvantage: There will be no more profits possible if the underlying instrument or stock rises beyond the strike price of the out of the money call option.