Hedging strategies

[wabmester]

In another thread, brewer said:

I am thinking that on the next idiot pop in the equity market (most likely a Fed relief rally, or something similar), I will be buying some long-dated index puts.

I have a fairly low allocation to stocks right now, so I'm fairly comfortable letting it ride, but I have been considering hedging my equity exposure.

What's the best way to do this?

Which index would you choose?  To me, it looks like QQQQ has been the most sensitive to the economy, but I assume those options are the most expensive due to higher volatility.    Would you try to match the index to your particular allocation?

How far out would you go, and would you try to match your put size to your total equity exposure?

I've also read a bit about "portfolio insurance" strategies, but it looks like a lot of trading is involved, and these strategies failed in the last big downturn.

Maybe I should move into Hussman's fund.

 

[eridanus]

QQQQ options are over-traded and so the premiums are low. A January '08 30 put is only $1. The Jan 08 44 call is $1.75.

 

[brewer12345]

I do this somewhat by the seat of my pants.  The big problem for me is that most of my positions are in individual equities and junk bonds.  So my portfolio might deviate from what the indexes do by a pretty wide margin on any given day, meaning that hedging with index options is not an exact science.  I approach this by allocating 1 to 2% of my portfolio for options and warrants.  Right now, most of that space is taken up by long calls and warrants, mostly on one industry (dry bulk shipping).  Since I assume going into the trade that any option I buy will go to zero at expiry, I make sure that calls are clearly and intentionally speculation and puts represent money I am willing to pay away for sleep-at-night insurance.

So how do I hedge?  I SWAG it, and I try to buy the cheapest puts available on an intrinsice basis.  Right now, volatility is modestly high and there is some fear in the market, so if you insist on hedging, you will pay up.  I am not willing to do so, since I am confident about ,y individual exposures.  But a few months ago, volatility was near a 52 week low and I was not at all comfy with the outlook, so I bought QQQQ puts in my account, and QQQ and IWM puts in my parents' account.  In retrospect, the modest amount of puts I bought for myself (notional equal to about 2o% of the portfolio) was too conservative.  If I were absolutely convinced that I needed to hedge, I would probably buy puts with a notional amount equal to at least 50% of my equity position.

But always be prepared to lose everything you spend on every option you buy.

 

[haha]

I'd go with the cubes. Volatility is what you want. And you get superb liquidity. THe semiconductor index is very economically sensitive, and it has already rolled over, but the liquidity is not as good.

Ha

 

[brewer12345]

I'd go with the cubes. Volatility is what you want. And you get superb liquidity. THe semiconductor index is very economically sensitive, and it has already rolled over, but the liquidity is not as good.

Ha

Yeah, illiquidity is a real problem. Bid-ask spreads on some of my individual name options can blow way out when volume slows to a trickle. Take a look at the bid-ask spread on PPDAH (Jan. 40 call on PPD), as an example.