How To Hedge or Protect Index Credit Spread Options and Iron Condor Options Against a Steep Correction or Stock Market Crash

This article discusses a strategy to hedge index credit spread options against a strong market sell-off or stock market crash. We analyze the October 2008 US stock market crash to back test this hedging or protection strategy. In addition to developing the mechanics of the hedge, we identify leading indicators that can give us an early warning when the US economy is deteriorating, identify signals that can help us decide when to open a hedge, and we summarize the hedging strategy in a concise set of rules.

We start our analysis by looking at the 17/43 exponential moving averages (EMA) on the weekly chart of the S&P 500 index, where the 17 week EMA crossed below the 43 week EMA giving us a bearish signal. We use the S&P 500 index because it is a proxy for the health of the US stock market, and overall US economy. We use the 17/43 weekly EMA because it does a good job of keeping investors in the market during bull markets, and out of the market during bear markets. Note how point A as shown by the arrow is a trigger to get into the market, and point B is the trigger to get out. The bearish 17/43 EMA crossover was an early technical warnings that the US economy was beginning to become unhealthy. This point actually represented the beginning of the recession, but this was not known for some time as economists took almost 9 months to announce that the US economy was in a recession and that it indeed started in December 2007.

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Next, we look at 100 day simple moving average (SMA), 200 day SMA and 50 day SMA on the daily chart of the SPX to provide us additional insight into the health of the US stock market and economy. Similar to the 17/43 week EMAs, the 50, 100 and 200 day SMAs do a good job of keeping investors in the market during bull markets and out of the market during bear markets. We can see that in Jan ’08 the 100 day SMA crossed below the 200 day SMA, which is bearish. In general, when we see the 50 day SMA below the 100 and 200 day SMAs, and when the 100 day SMA is below the 200 day SMA, the stock market is not healthy and investors need to be cautious. The bear market, however, was not confirmed until April when the SPX tried to rally and hit resistance at its 100 day SMA, which told us that there was a high probability that we were in a bear market. Let’s now take a look at implied volatility, the VIX, also known as the fear index.

In addition to the 17/43 weekly EMA, and the 50/100/200 day SMAs, let’s look at the VIX, which represents implied volatility, or fear. We can see that the VIX increased by 95% from mid May to mid July. This is a warning that a major storm could be coming. However, note how the VIX dropped by 40% from July to late August; and we now know that this was the calm before the storm, so just because the VIX pulls back doesn’t mean that everything is ok. In general, when we see volatility doubling in a few months, this is a big red flag. Let’s now look at some additional macro-level economic indicators to confirm that we are in a bear market.

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Below is the high-frequency (i.e. it’s updated weekly) Aruoba-Diebold-Scotti Business Conditions Index. This macro-economic indicator is composed of 12 separate indictors ranging from job growth, bond rates, consumer spending to manufacturing output. We can see that it started to weaken in Jan ’08 and actually gave a clear signal in August ’08 that the US economy was rapidly deteriorating.

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Below is the ISM index that describes manufacturing output, showing that manufacturing output was gradually weakening and crossed down through the 50 threshold in January 2008. When the ISM index is below 50 it tells us that manufacturing output in the US is contracting; and when it’s above 50, it tells us that manufacturing is expanding.

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Below is the Initial Unemployment Claims index that tells us the number of newly laid off workers that are applying for unemployment insurance. When this number is above 400k claims, it tells us that the US economy is losing jobs, and when it’s below 400k claims, it tells us that the US economy is adding jobs. Note how the 400k threshold was crossed in July ’08 telling us that the US economy was beginning to lose jobs.

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Below is the interest rate spread between similar maturity corporate bonds vs. US treasuries. When interest rates for corporate bonds (debt) are high as compared to US treasuries, the bond market is telling us that there is a higher risk that US companies will fail, and as a result investors demand a higher interest rate when buying the corporate debt. This represented one component of the credit freeze that ensued during the ’08/09 recession where companies had a hard time raising capital because corporate debt interest rates were so high.

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Below is the Conference Board Leading Economic Index (LEI) that is similar to the Aruoba-Diebold-Scotti Business Conditions Index, where it comprises a dozen economic indicators. We look at a few of these broad based diffusion indexes since each is composed of different sub-indexes and the economists weight their indicators differently. We can see that we were getting an early warning that the US economy was deteriorating.

Below is the S&P/Case-Shiller Home Price Index and we can see that housing prices peaked in early 2006 and then started to deflate through mid 2008. A bubble in residential home prices happened to be one of the primary causes of ’08/’09 recession, so this indicator did give us an early warning of impending danger in the stock market.

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In conclusion, the additional macro-economic indicators show that the US economy was deteriorating, starting in January 2008, and after the SPX attempted to rally in April 2008, and failed to over take its 100 day SMA, this was the definitive signal that a bear market had begun. In response, as of April ’08 the latest, it was time to open a hedge to protect ourselves against a possible stock market correction, or a crash.

Below is a case study that opens a hedge in April 2009. Per our discussion above, this is the time when most economists agreed that the US stock market was in a bear market. We use the example of opening a hedge to protect 10 Russell 2000 index bull put credit spreads.

Below we open 10 Apr08 RUT bull put credit spreads on March 19, 2008. We bring in a credit of $1000 for a total potential profit of 11% in 29 days, which is a typical return when we complete the iron condor. Risk capital is $10,000 in required maintenance less $1000 of collected premium = $9000; potential return is premium collected/risk capital = 1000/9000=11%. For more information on how to read an options risk/reward graph please visit the MCTO Learning Center and read the entry entitled How do you read the risk/reward graph?.

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Below is a daily chart of the RUT from Jan ’08 through Sep ’08. The vertical line is March 19, the day that we open our quantity 10 April iron condor. Notice that just by looking at the chart, it’s hard to tell that the US economy was rapidly deteriorating. Thus, it’s essential to monitor the macro-level indicators that we discussed above to give you a true picture of the health of the economy.

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Because the results of our technical and macro-economic analysis told us that it would be prudent to open a hedge, let’s open some protection. In order to create a hedge that is effective throughout the life the option, we first open a Dec08 600/550 bear put spread, where we buy the 600 put and sell the 550 put, which finances about 70% of the cost of the 600 put. The Dec08 600/550 bear put spread is shown below. The problem with only opening a bear put spread is that in the early months of this hedge, for example riding on the red line that represents the value of this bear put spread in March through April, we don’t get a lot of protection, especially if the RUT only pulls-back to 530, for example. Note that the maximum protection kicks in when this bear put spread is close to expiration, where the value maxes out at $3000 when the RUT is below 550. We can see that in order to collect the full $3000 in insurance, the RUT will need to stay below 550 and we will need to wait the full 274 days.

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In order to better optimize our protective hedge where it will be equally effective over time, we add a Dec08 far out-of-the-money (OTM) 400 Put, where the Dec08 600/550 bear put spread + Dec08 400 put is shown below. This hedge costs $2,105, or about 2 to 2.5 months worth of gains, but once we pay for this insurance it will be effective for the remainder of the year, through the 3rd Friday of December. We use the ratio of Qty. 1 hedge per 10 bull put credit spreads. As a side, if we are able to time the purchase of our hedge to coincide with a strong UP day, the price of our hedge could be lower, maybe up to 30% lower.

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Below is the implied volatility vs. value of the hedge. Notice how the value of our hedge increases as volatility increases. When a stock drops, volatility, or fear, usually climbs. Thus, in the case of a stock market correction, volatility will increase, and as a result the value of our hedge will increase. As an example, when we are 184 days until expiration, let’s say the RUT pulls back to 485 and volatility doubles from 33 to 66. Riding on the blue line, we can see that the value of our hedge climbed by about $3,300 from the effect of volatility climbing to 66 (using the graph below), and the value of the hedge increased by an additional $3000 from the RUT dropping to 485 (using the graph above), for a total increase in value of our hedge of 3000+3300=$6,300.

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Let’s review the effectiveness of the hedge:

a) Risk capital required for 10 RUT bull put credit spreads is $9000 (max potential loss)

b) In the event of a fast moving market correction, we assume that we’re able to close the 10 bull put credit spreads with a loss of 50%, which is somewhat realistic in the event of a correction of 20% or more in a handful of days. Thus, we lose $4,500 of our $9000 in risk capital.

c) The hedge needs to cover some or all of the $4,500 loss; from the risk/reward and volatility vs. value of hedge graphs shown below, we an see that the hedge can easily cover the $4,500 loss if the RUT pulls back hard. However, the value of the hedge is dependent on how far the RUT moves, and how high volatility climbs. Overall, the hedge looks to be effective.

Summary of Rules:

1) Wait for the macro-economic and big-picture technical analyses to tell you that the US economy and the stock market are deteriorating.

2) The cost of opening a hedge is a sunk cost and we need to be prepared to lose 100% of the premium that we paid. Just like buying insurance for a car or house, the premium that we pay is a sunk cost, regardless if we use it or not.

3) Because we accept the fact that this insurance is a sunk cost, we will not place a stop-loss on the trade. We will hold the hedge trade until it expires.

4) Open 1 hedge for every 10 bull put credit spreads. If we want less costly insurance, that will also payout less in the event of a crash, we could increase the ratio to 1 hedge for every 15 bull put spreads.

5) To create the hedge, buy a put that is about 1 year out with the same strike price as the short put in the spread. For example, let’s say we have RUT Feb 540/550 bull put spread where we sold the Feb 550 put and bought the Feb 540 put. We would buy a Dec 550 put, and sell a Dec put about 10% under the Dec 550 put, or at the approx. strike price of 500. To complete the hedge we would buy a far OTM Dec put 25% to 30% below the top 550 leg. In this case, 25% of 550 is about 135, 550-135=415, so in this case we could select the 400 strike. The resulting hedge for this example would be a Dec 550/500 bear put spread + Dec 400 put. Said another way, we would have a long Dec 550 put, short Dec 500 put, and a long Dec 400 put.

6) Because it’s usually not urgent to immediately open a hedge, try to wait a week or two to see if the underlying index will rally a little to reduce the cost of the protective Puts. In general, when buying Puts to create a hedge, wait for an UP day, which will reduce the price.