Buying deep OTM put options

Discussion in 'Options' started by Lucias, Jun 30, 2011.

  1. Lucias


    One of my futures strategies does best with a catastrophic stop. The problem with such a large stop is the psychology and having a huge loss and also having to close such a position out.

    I see 2 ways of mitigating this issue:

    A. Trade the vertical or call spreads instead of the futures. I am trading this system at NADEX and performance is good. I feel futures are the most efficient market. Right now its not an issue as my size is less then $50/point.

    B. Buy deep out of the money put option.

    I would like to get any opinion or experiences with using such options to protect against an active futures trading. Right now I can purchase the 1270s about $575 -- not sure when that expires though.

    In other words, instead of using stops, I'd carry a few deep otm put options and trade in-and-out without worry and without stops.

    I'm looking feedback for the feasibility and expense of using such a strategy and how it would compare to always buying the limited risk/reward spreads.

    Howard, so what you are doing is selling the put/call spreads OTM? I.e I buy the 1260 put and sell the 1275 put then I collect the full amount if we close above 1275?
  2. your trading platform should say how many days til expiry

    you should always trade w/ a stop period not just a catastrophic stop b/c what if price goes just above your cat stop a few times - you'd be wiped out.

    buying OTM puts are my preferred way of hedging - the simplest and most direct.

    don't know why you're trading nadex - stick to exchange listed options/futures (no i don't consider nadex an exchange like cme)
  3. Lucias


    Let's talk about how you hedge with these puts. Do you buy them when you enter a trade and then trade them out? This could be a problem for a dip buyer because the volatility would be high.

    Another strategy would be to keep them on the books, so to speak. Buy then with volatility is low and buy them far dated into the future.

    I can still see a few problems

    1. The option may not increase in value "fast enough" to offset the futures losses
    2. Selling them out in time to lock in gains. For example, during flash crash one might want to sell them out. Was it possible?
    3. Far dated options will constantly bleed to time decay
  4. sle


    I assume you are talking some sort of algo or stat arb strategy. Here is something for you to think about - are your strategies long or short realized volatility? In general, mean reversion strategies are long realized volatility and trend strategies, as well as various fundamental strategies are short realized volatility. However, its worth checking for yourself. If you are a trend follower, having a tail hedge useful, otherwise you are going to be doubling up on the same risk factor (going long volatility when you already are long volatility).

    Just my 2c.

    PS. also, how much of a catastrophe/tail are we talking about? Maybe the right way is to hold some sort ratio spreads (e.g. 1275/1250 1x2).
  5. Lucias


    Exactly.. I use both momentum and mean reversion strategies. I am more concerned with the mean reversion strategies. This is why I'm inquiring about buying the hedge before hand and keeping it on the books.

    This is a good question. How much? Truth be told, I will probably use the bull spreads to manage my risk. But, if I wanted to trade optimally I'd probably have about a 35 point stop. So, I'd need to buy a put 30 to 40 points OTM.

  6. NoDoji



    The strategy either "does best" as you say or it doesn't.

    Is this strategy net profitable or not?

    If it does well with a catastrophic stop, then there's no problem, because you know that over time the frequent profits are outweighing the occasional catastrophic stop that gets hit. Wouldn't hedging with options simply mean you're diluting your potential profit because you're unable to accept your catastrophic stop loss being hit?

    If you're psychologically unable to handle taking the occasional large loss in an overall net profitable strategy, then dump the strategy. It's not worth the stress.

    I used to be a RTM trader and my large losses wiped out way too much of my profits. I learned to trade technical price action and I have no unnecessary stress while trading. I curse a bit when I take profits too soon for no particular reason, or when a bit of greed convinces me to hold a trade past its prime and give the whole profit back, but day-in/day-out, trading is a basic routine with the risk on every trade smaller than the reward and winners outweighing the losers.

    IMHO, it's well worth mastering techniques that eliminate catastrophic stops and the stress involved with holding losers over time.
  7. Lucias


    The strategy is only in the market for 1 day and is very strong. I take every trade with my real money. But, I started trading at NADEX because I'm not trading full size contracts.

    While I can't backtest the options to the same degree as the futures, the system is profitable using a variety of instruments/methods. The futures system returns the highest net profit. I'm willing to pay a slight bit of insurance to avoid the catastrophic losses. But, I haven't taken into account the possibility of leveraging it higher which could give a different take.

    But I'm also thinking about how I could trade in future with my discretionary trades without using a stop.

    I'm trying to understand the differences between deep ITM puts versus bull spreads.

  8. NoDoji


    I don't know how much trading experience you have but I've seen many retail traders fail to become consistently profitable as a result of 1) an inability to accept losses as a normal cost of running a probability-based business and, 2) an overwhelming desire for perfection (also known as a need to be "right").

    You have a net profitable system, which is something everyone dreams of having.

    If you were a professional asset manager who maintains large positions for a period of time, then hedging makes sense.

    But as a retail trader doesn't it make sense to use your catastrophic stop loss (which doesn't hurt your net profitability) than to use no stop and dilute your edge by hedging positions that are intraday holds?
  9. Still there. Still doing that. I fight these demons every trade. Keeping a journal, carefully reviewing my trades for trader error (that would be me) and seeing if the performance is within expectations are my coping methods.
  10. In general (and this may be slightly off-topic), read Montier's excellent piece on "black swans".
    #10     Jul 1, 2011