Guest Author: Bill Speth, Portfolio Manager, Bosun Options Solutions

Toward the end of 2024, many Bosun clients shifted their focus from capital appreciation to capital preservation amid growing concerns about a stock market correction. In recent months, a number of sell-side firms have lowered both short- and long-term forecasts for the U.S. stock market. Goldman Sachs has estimated that the S&P 500 will deliver an annualized nominal total return of 3% over the next 10 years^1. Over the last 10 years, annualized returns were 13%.

Some investors who desire to reduce risk will simply sell their riskier holdings and replace them with safer assets.

But many investors are unable or unwilling to do so. For example, investors who purchased shares at a low basis would face a significant tax event were they to sell their stock. Additionally, they may have an affinity for being a shareholder in a company they have owned for a long time.

Options-based hedges provide investors with the opportunity to hedge risk while minimizing stock sales.

The following is meant to serve as a guide to how Bosun thinks about option-based hedging.

An Introduction to Option-Based Hedging

Hedging involves taking a position in one or more financial instruments that will directly offset losses in a related asset. Options are particularly useful tools with which to construct hedging strategies. With thousands of unique contract terms available for each security, one can create hedges that target precise levels of protection and cost.

The table below lists three option strategies commonly used for hedging, each with a different balance of protection and cost.

^{Payoff diagram icons shown under “Option Strategy” header are illustrative and not meant to describe precise payoffs. Shapes of payoff diagrams and strategy descriptions apply only to investments held until option expiration.}

Like other forms of insurance, investment protection is not free. Buying a put requires an up-front payment in the form of the option’s premium but there is no limit to future upside appreciation. There is also a very real possibility that the actual down move doesn’t take place immediately and you may need to maintain a hedge for several months. We find that few investors are willing to use this strategy.

Collars, on the other hand, tend to be more appealing. They can be structured with minimal or no initial cost, though they come with limited upside potential. Buffered collars provide protection over a limited range of stock price moves and improved upside participation compared to a standard collar. Investors who place a high value on potential upside often prefer buffers to collars.

Buffered Protection Collar – A Case Study

Bosun recently helped a client hedge a blue chip stock in their portfolio. The client wanted to protect the gains accrued over many years but did not want to pay substantial capital gains taxes as a result of selling shares. They were willing to accept some losses if the stock fell but wanted to hedge against a major drawdown. The client’s long-term outlook was positive, so they would look to be a buyer of additional shares if the price fell by at least 30%. They also requested a hedge with minimal cost, provided the structure offered meaningful potential for upside appreciation.

Bosun initiated a buffer protection structure intended to hedge losses in stock over a range of 8% down to 29% down until January 2026. Bosun eliminated the risk of selling stock as a result of an option exercise by using European-style FLEX options. The figure below illustrates the defined payout of the hedge if held to maturity. The hedge offers:

• No protection for the first 8% of losses,
• Full protection from 8% to 29% of losses
• No additional protection if the stock falls more than 29%

In return for receiving this protection, the client accepts a maximum upside potential of 22% above the then-current price of the stock.

^{Source: Bosun's calculations based on data from FactSet, as of 2/24/2025. All figures net of fees based on end-of-period balance. Requires holding investment strategy to expiration to get payoff shown.}

Interim Results

Through the close on Thursday March 13, the stock was down 9% from its price when the hedge was initiated. By comparison, the buffer strategy was down just 4%.

This means the hedge has helped the investor reduce stock losses by more than 50% so far.

Strategy Considerations

Strategy Time Horizon

The primary advantage to running strategies with a longer length to maturity is that the options have more time premium. Because the investor is selling two options and buying one, the extra time buys more potential upside relative to a structure with a shorter maturity.

The primary disadvantage is that longer dated buffer protection structures take longer to maximize their value.

Exiting a Hedge Early

The figure below shows the estimated performance of a buffer with protection between 10% and 30% down and an upside cap of 22%. The hedge kicks in well before the 10% “deductible” is achieved. Notice that the expected hedge returns at 10 months, 4 months and 1 month to expiration are greater than expected returns at maturity until about halfway through the protection buffer range.

^{“10M” reflects the estimated performance of the buffer hedging strategy 10 months prior to maturity, “4M” represents 4 months prior to maturity, and “1M” represents 1 month prior to maturity. Expected returns shown are estimates based on forward projections of option implied volatilities at different strike price levels and maturity dates. Actual option pricing may vary substantially from these estimates. Price data for estimates sourced from FactSet.}

If a stock falls substantially prior to expiration, it may be rational for an investor to exit a hedge early. Bosun recommends that once a client has received about 90% of the maximum value of their hedge, the investor should consider exiting.

The hedge might need other adjustments as the stock price moves, especially if it rises above the strike price of the call option. If the hedge doesn't provide the level of protection needed due to stock price movement, Bosun may recommend that the client close the existing hedge and open a new hedge with a longer maturity and different protection ranges and upside levels. This would allow more time for the stock price to fluctuate while still providing protection.

The ability to exit early and adjust at any time is a key reason some investors use options to manage risk of their concentrated positions.

Path Dependency

Because options have an expiration date, the timing of an underlying price move is critical to strategy performance. For example, if a big down move takes place a day after a hedge expires, the return will look much different than if it took place a few days earlier. As such, Bosun advises clients to use overlapping tranches of hedge protection spaced out in time to smooth the impact of path dependency. This approach also allows for an averaging effect of strike exposures as the underlying price moves up and down over time.

Final Thoughts

As investors face uncertain market conditions and heightened concerns about potential corrections, option-based hedging strategies provide a flexible and effective way to manage risk while retaining exposure to potential upside. Whether through buffered collars or other option structures, these strategies allow clients to protect against significant down-side while minimizing the need for asset sales, which can have tax implications or disrupt long-term ownership preferences. Bosun’s approach emphasizes flexibility, with the ability to adjust hedges as market conditions evolve, and the option to exit a hedge early once it has fulfilled its protective function. By carefully considering time horizons, protection levels, and the dynamics of the market, investors can strategically safeguard their portfolios while positioning themselves for future growth.

^{[1] Goldman Sachs, GLOBAL STRATEGY PAPER NO. 71 Updating our long-term return forecast for US equities to incorporate the current high level of market concentration. October 18, 2024.}

About the Author

William (Bill) Speth brings over four decades of expertise in options and futures markets, blending deep theoretical knowledge with hands-on experience in investment management. Currently the Portfolio Manager at Bosun Options Solutions, Bill has played a pioneering role in developing innovative financial instruments and strategies that have shaped modern derivatives markets.

Prior to his current role, Bill served as Senior Vice President and Global Head of Research at Cboe Holdings, where he was instrumental in the creation of groundbreaking products such as options and futures on the Cboe Volatility Index (VIX). His leadership also drove the development of options-based strategy benchmark indexes and the launch of landmark products, including the first “covered call” ETF and the first ETNs based on VIX futures.

In addition to his portfolio management responsibilities, Bill serves as Senior Advisor for Membership to the CEO of the World Federation of Exchanges (WFE), contributing his strategic insight to the global exchange community.

Bill holds a Bachelor of Science in Physics from LeMoyne College and a Master of Science in Electrical Engineering from the University of Rochester.

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