Averaging Down with Option Hedge

Discussion in 'Risk Management' started by jones247, Oct 20, 2009.

  1. Many folks contend that averaging down is a "time bomb waiting to explode", and I agree. For example, you could experience years of success with averaging down; however, it will only take a "one time" failure with averaging down to blow-up your account. This has been the case with several high profile hedge funds & traders (i.e. LTCM, Victor Niederhoffer, Societe General & others).

    What if... the positions were hedged... In other words, using a protective put or a ratio backspread, one would be able to avert "black swan" type disasters.

    The drawback with these instruments is the fact that the put is quite expensive and will materially eat into your profits, even if you tried to gamma scalp to offset the cost of the put. Of course, gamma scalping could create an opportunity if the positions are prematurely liquidated during a strong trend with little or no pullback. Gamma scalping works best if you can time the whipsaw/support & resistance levels. Bottom line... will the insurance be worth it???

    A major drawback with the backspread is that it only protects about 90% of your account balance. Also, you'll need to try to prevent being pinned at expiration. In other words, it's more probable for it to be more expensive than the put.

    btw... a collar would not work, as it prevents me from gamma scalping or to trade around the equity position up to the number of hedged shares via the protective put.

    In a nut shell - Averaging down is a potentially viable solution, as long as you can protect/insure your position!!!!!!

    Any suggestions on a more cost effective insurance methodology????


  2. Scalp Intraday inside a trading range bound by an options hedge.

    Buy OTM Puts and Calls 10 - 15 strikes out to wrap a trading range of +/- 5 strikes. (This is a Fixed $ hedge and not based on # of contract per se. ie. $5000. You are hedging in terms of $ risk)

    Scale the options hedge up to cover 50% of your draw down.

    Scalp like a mad man and when you hit the inevitable limit.

    Liquidate the options every 5 strikes and replace provided all positions have exited at profits.

    If Not: Liquidate the hedge and all positions take a 50% safety stop loss.

    The profits derived over time from the options straddle should contribute to mitigate the inevitable safety stop losses.

    You bled but live to trade another day.

    The Options Hedge is insurance for survival. Don't try to cover 100% of the risk or else all of your scalping profits will go into the options.

    There is a balance and it is dependent on the underlying trading activity.
  3. thanks for the feedback, Pocket. However, I don't understand some of your points. Are you willing to give an example?