Hedging strategies

[wabmester]

I am such a procrastinator. I was seriously thinking about buying some puts prior to 2/27, but I didn't pull the trigger. And now VIX has gone mad.

I will probably buy some anyway and just accept the punishment, but I an not an options expert, so I have some questions before I do.

How efficient is the options market? Does everybody sit there with their Black-Scholes calculator, or are there some deals? Is there some software that would help me select from the zillion different hedging possibilities?

Anybody doing something besides simple puts? Maybe bear call or put spreads? Zero-cost collars?

What's your hedge?

 

[LOL!]

I've only done some covered call selling and call buying, so I what I have to write may not cover what you want to know.

I built an Excel spreadsheet of my stock holdings and had the MSN Stockquote plug-in to give me options pricing and the underlying share pricing. I had fields turn GREEN when it was a good deal to sell the covered call, where "good deal" fit a specific set of criteria I was looking for (as programmed into the spreadsheet). So I just had to open the spreadsheet and if I saw green, I would think about making the trade.

What I found is that
(1) Nobody runs Black-Scholes because I think the numbers are run for you and given as the "time value" in the quote.
(2) The market is not efficient. Many strike prices have no trading and even reasonable trades have a very low volume most days. The trading is done in spurts.
(3) For software, you can use Excel as long as you can program the hedging possibilities yourself. The beauty of doing your own spreadsheet is that you will need to understand the hedging strategy in order to put it into Excel
(4) Sometimes my spreadsheet would be green for a good trade, I would mull it over and 30 minutes later the trade was no longer green.

In other news, I made money in options, but not enough to make the mortgage payment, and the pay rate (hours invested versus return) was low for me.

 

[Olav23]

If you stick to near the money index options, there is probably enough liquidity to make it "efficient". Will these be incredibly lucrative? Maybe, maybe not.

 

[brewer12345]

if you stick to SPY or QQQQ options, the market seems to be pretty efficient. If you go further afield, you will pay up.

I usually don't hedge, but when I do I tend to stick with QQQQ puts.

 

[saluki9]

I am regulary in the SPY options market for clients. It's very liquid out to about 13 months.

 

[clifp]

I have been purchasing IVV instead of SPY because according to M* IVV had slightly lower expenses and better tax efficiency.

However there is an active options market for SPY, and pretty small illiquid market for IVV options.

I did write some covered calls as hedging strategy at the end of last year but decided that premiums were too small compared to the risk. Not that volitality has increased it maybe time to revist that decision.

 

[chinaco]

I believe options can be used in a variety of ways to hedge. However, I have not had a reason to do so. I do not short-sell either. Short-term market swings are too unpredictable... at least beyond my skill level to use it effectively!

My advice: Go Long Baby! 8) 8) 8)

My opinion: Options, Futures, Short-selling is too much like gambling unless you are very sophisticated, have access to the right information and know what you are doing.

I would only consider options to lock in on something that I could not liquidate now. If you are that worried, consider liquidating some stock and parking some money in a money market fund for a while.

I have considered using Leaps to lock in a floor on some company stock (quite a bit of it) that cannot be sold till retirement. Mainly to ensure that the retirement is not postponed due to a drop in the price. In the case described, I would be using it as insurance against postponing retirement. If I could sell the stock it would not be a problem.

 

[FIRE'd@51]

Personally, I tend to favor the SPX's (options on the actual S&P 500 index - not the ETF). They are cash-settled, European-style exercise, and have a favorable 60/40 tax treatment if held in a taxable account.

 

[haha]

Anybody doing something besides simple puts? Maybe bear call or put spreads? Zero-cost collars?

If you go deeply into this, get a good options book. I have a few, but I'm away from home and can't remember the names. Many complicated strategies can be deconstructed into much simpler single option strategies. I think they may make sense for a professional very low cost trader/arbitrageur, but for the sort of things I have done I just buy puts. And, I would simply sell stocks in preference to this, were it not for capital gains tax that would become due.

After several years of messing around with this, I have won some, lost some- but overall lost more than I won. Still the stocks that I hold have gone up much more, so in a portfolio context it might not be bad.

Also, lately things do look as if they are getting seriously messed up, so your timing might be excellent.

Another possible bear play would be something like Access Flex Hi-Yield Bear AFBSX. It has high expenses, and of course it is short a fairly high coupon- but it does seem that credit quality is where the stresses are showing up.

I don't own it.

Ha

 

[wabmester]

So, I'm googlin' around, trying to decide on my hedging strategy, when I read about this guy who is buying puts against a CEF called Cornerstone Total Return Fund (CRF).

It doesn't look like it paid off for him, but this has got to be the weirdest CEF I've ever seen. It trades at a 103% premium to NAV! Anybody want to take a shot at explaining this oddball? Looks like people are getting suckered by the high yield, which has to be return of capital.

 

[brewer12345]

Yup, they specifically mention that much or all of the divs are a return of capital. But there is no guarantee it won't got to a 200% premium.

 

[wabmester]

Yup, they specifically mention that much or all of the divs are a return of capital.

I guess that's why they call it the "total return fund." They simply return your capital to you. Amazing.

 

[wabmester]

I decided to simply buy some puts. I bought June-130 SPY puts at 1.18. If the 130 puts become in the money, that'd represent a market drop of about 7%. I looked at the same drop in QQQQ puts, and the insurance was more expensive on a percentage-of-coverage basis. Plus my port looks more like SPY than it does QQQQ.

I've only covered a small portion of my portfolio, but I may average in, extend expiration dates, or something. This is so confusing.

Feel free to critique.

 

[brewer12345]

I decided to simply buy some puts. I bought June-130 SPY puts at 1.18. If the 130 puts become in the money, that'd represent a market drop of about 7%. I looked at the same drop in QQQQ puts, and the insurance was more expensive on a percentage-of-coverage basis. Plus my port looks more like SPY than it does QQQQ.

I've only covered a small portion of my portfolio, but I may average in, extend expiration dates, or something. This is so confusing.

Feel free to critique.

MAkes sense. You could buy different expiry dates and strikes over time.

 

[Olav23]

I guess that's why they call it the "total return fund." They simply return your capital to you. Amazing.

And don't forget, charge you 1.5% to give your own money back to you. Now that is what I call free trade capitalism!

 

[justin]

I bought June-130 SPY puts at 1.18.

Assuming SPY had a market price of 138 when you bought June-130 SPY puts at 1.18, that means you're paying around 0.85% for the insurance that your losses on the "insured" part of your portfolio are limited to no more than 6-7% for the next ~3 months? Just trying to make sure I'm analyzing this the correct way.

Plus you get to keep all dividends paid (if any) prior to exercise (if it happens), right?

 

[wabmester]

Assuming SPY had a market price of 138 when you bought June-130 SPY puts at 1.18, that means you're paying around 0.85% for the insurance that your losses on the "insured" part of your portfolio are limited to no more than 6-7% for the next ~3 months? Just trying to make sure I'm analyzing this the correct way.

Plus you get to keep all dividends paid (if any) prior to exercise (if it happens), right?

Yup, that's basically the way I see it. But even a short-term smaller drop would increase the value of the puts, so the other part of the equation is when to sell them (and perhaps "roll" them down).

Part insurance. Part tuition.

 

[FIRE'd@51]

I decided to simply buy some puts. I bought June-130 SPY puts at 1.18. If the 130 puts become in the money, that'd represent a market drop of about 7%.

So it looks like you paid about an 18% implied volatility for your puts. Assuming you paid a "fair price" for your puts, the market is saying there is about a 16% chance (one SD) that the S&P will drop by 9% or more over the next 3 months, or, alternatively, there is about a 22% chance your puts will finish in the money.

 

[wabmester]

So it looks like you paid about an 18% implied volatility for your puts. Assuming you paid a "fair price" for your puts, the market is saying there is about a 16% chance (one SD) that the S&P will drop by 9% or more over the next 3 months, or, alternatively, there is about a 22% chance your puts will finish in the money.

Aha, I was right. People do sit there with their Black-Scholes calculator on the other side of my trade. Can I cross-check that implied volatility calculation directly with something like VIX?

Edit: BTW, SPY was at 140 or so at time of purchase, so the targeted drop is closer to 7% than 9%.

 

[FIRE'd@51]

Aha, I was right. People do sit there with their Black-Scholes calculator on the other side of my trade. Can I cross-check that implied volatility calculation directly with something like VIX?

I believe the VIX is based on 30-day options but it could be a rough indicator.

I used 140 for SPY to calculate the implied volatility.

 

[ERD50]

Assuming SPY had a market price of 138 when you bought June-130 SPY puts at 1.18, that means you're paying around 0.85% for the insurance that your losses on the "insured" part of your portfolio are limited to no more than 6-7% for the next ~3 months? Just trying to make sure I'm analyzing this the correct way.

You must also consider that wab is using SPY as a proxy for his portfolio. There is probably good correlation, but if one stock or sector decides to tank, it might impact the portfolio and have little impact on the SPY.

Plus you get to keep all dividends paid (if any) prior to exercise (if it happens), right?

Well, he gets to keep any dividends on the stock he didn't sell, of course. But the buyer of a put does not receive dividends, you need to hold shares for that.

http://www.cboe.com/LearnCenter/Concepts/Beyond/general.aspx

I'd agree with chinaco - the best hedge is to simply sell. You cannot lose money on what you do not own. Hedges cost money, if the stock does not go down, you ate into your profits. It can make sense to hedge if you do not want to sell for tax reasons, or to lock in a stock price on employee options that you cannot exercise yet.

Otherwise, it's kind of an emotional thing - which can be useful. If, by having the 'insurance' of a protective put, it helps to keep you in the market and participate in an upswing that you may have missed entirely, it could be well worth it. I think this is what wab is trying to do. I have done it when I really wanted to hold a stock through an earnings announcement, but was afraid bad news could tank it. It's like any insurance, you can't really expect to profit from it directly, but the protection it provides may be worthwhile.

-ERD50

 

[wabmester]

I'd agree with chinaco - the best hedge is to simply sell. You cannot lose money on what you do not own. Hedges cost money, if the stock does not go down, you ate into your profits. It can make sense to hedge if you do not want to sell for tax reasons, or to lock in a stock price on employee options that you cannot exercise yet.

You lose all possible upside by selling. I could have done a zero-cost collar if I wanted to lock in gains without selling, but I just want to insure against some downside risk.

Looks like I've already paid some tuition, though. Found an options calculator here:

http://www.ivolatility.com/calc/

The options closer to in-the-money seem to be better deals with lower IV.

 

[FIRE'd@51]

The options closer to in-the-money seem to be better deals with lower IV.

That's pretty much been the case with index options since the 1987 crash. The lower the strike, the higher the implied volatility. I believe it's because gap moves in indexes tend to occur more on the downside (like '87). In general, very bad down days are worse than very good up days are good, so the market makers price options accordingly, since it's the gap moves that upset their hedges.