If a client has a large concentrated stock position with lots of capital gains, is there any way to hedge that position more efficiently than a put option?
My firm was discussing exchange funds and the question was raised, ‘are put options the cheapest hedging route’? My expectation is that they are the cheapest, but just wondering if I’m wrong about that.
equity swap/cfd?
will a swap be more cost effective than a put option? Say a swap of 3M for the S&P 500
The answer is very nuanced. When you buy put options, you are buying volatility and convexity. It will be “cheaper” to use puts if realized volatility ends up being high. If the market does not move much, you would have paid for a lot of volatility that out did not use. Buying options means taking a long view on volatility. It is not just a delta strategy. A put that cost 10 cents is not cheap. It might in fact be expensive relative to the associated volatility scenario.
Equity swaps are volatility neutral. You would use them if you want to convert a fixed delta of your portfolio to cash under all circumstances. It is theoretically costless, other than the funding spread you will pay to the dealer. However, unlike puts, you will lose the potential gains of the market goes up a lot.
The best way to answer this question to people who don’t know anything about derivatives would be to plot out the possible portfolio returns: -10%, -5%, 0, +5% and so on. Then calculate the return in those scenarios if you had used puts or swaps. The pattern of puts or swaps being better under different scenarios will become clear.
Also, either of these strategies will incur trading costs. With puts, you will need to roll the position as it expires. With swaps, you will pay a fixed spread for as long as the trade exists. At some point, it is cheaper to just take the realized gain.
I think cfds are cheapest
I imagine that has a lot to do with the volatility…and time horizon. As time and vol increases, price of put increases
you could also buy a put / sell another put to potentially reduce hedge cost (with less of a hedge)
Thanks guys, I appreciate the help.
Here’s a likely scenario that might help clarify my question. Say we have a client with $6M net worth and 5 of it is tied up in 3M. Also assume that cost basis is $10K or something extremely low. That client has several paths he can take. He can continue to hold the majority of his net worth in a single stock, he can sell the stock and diversify (and pay the associated tax bill), he can buy put options, or he can utilize an exchange fund.
The exchange fund eliminates the single stock risk, doesn’t generate a tax bill and has relatively minimal costs.
To use put options over and over for many years would be costly. The question was raised, would a swap (3M to SPY lets say) be more cost effective than put options?
My guess is that in this scenario, both put options and swaps will be significantly more costly than the exchange fund and will not defer the tax bill nearly as well as the exchange fund (if the put option pays off because 3M sells off…that tax bill needs to be paid that year). So I think the exchange fund is the best bet…but I want to respond in an educated way on the cost of exchange funds, rather than just assuming that they’ll be too expensive.
I reached out to JPMorgans investment banking department, so perhaps they’ll be able to give me some exact numbers on a $5M MMM for SPY swap.
where is he located, is he American?
I’m not sure about exchange fund…but looks like you’ve narrowed it down to two:
I would say between cfd and exchange fund if in Britain/etc
or between equity swap and exchange fund if in US
yes, in the US.
The reality is that the tax implications far outweigh the cost of the put or the swap, but I want to provide a cost analysis of swap vs. put option as well. Both options and swaps will be very tax inefficient relative to the exchange fund, so the actual decision for this client is an easy one.
I would think swaps would be best. With swaps you are paying Libor + a spread, whereas with options you are paying premium. Obviously, if the cost of vol is low enough, maybe the option would be best, but I suspect the swap would be more efficient.
Of course if you can’t get a swap, that spoils the fun.
bchad, do you have experience executing these? what would prevent us from getting one? And do you know what other types of fees would be involved?
Using my example, $5M of 3M and swaping that for a genaric equity index return.
I don’t have experience doing these myself, though I’ve done some modeling for people that do use these.
Usually the issue is whether you are a reliable counterparty, which means you are either an institution like a bank or a major fund, or you have collateral or some relationship with your counterparty such that they trust that they won’t have to send their lawyers after you when it’s time to true up the swap.