Buying Puts for a potential crash?

toben · Dec 15, 2017

Hello,

I need help using options to hedge against a huge market crash similar to the year 2000 or 2008.

This should be a protective strategy so if the markets don't crash, I didn't lose too much money buying insurance. I am going to invest 0.5% in buying puts.

I have about $400K in the market and want downside protection. Therefore I am probably going to invest about $2K over the next year in puts way out of the money.

My best guess is to buy puts against the russell 2000 via the IWM etf.

I am trying to figure the best way. Should I buy monthly puts, or every 3, 6 or 12 months?

What are your suggestions?

Thanks in advance!

jimmyjazz · Dec 15, 2017

Food for thought:

1. I would remain open to rolling your puts if the market continues to trend higher; otherwise, you are losing protection.

2. I would definitely explore the time decay for a given amount of downside protection as a function of time to expiry

caacapital · Dec 15, 2017

I would do long put spreads calendar ratio and get only get a small portion naked. id do as long as possible the spreads will cut your cost significantly.

spindr0 · Dec 15, 2017

Geez, this is a lot harder to describe than to just do. Hopefully this will make some sense.

A crash is different than a bear market. 1929 and 1987 were crashes. Unless you had some form of negative correlation protection in place prior to them, you took it on the chin. Bear markets like 2000 and 2008 took 18 months to unfold so they offered lots of time to react and adjust, namely transitioning to cash and if you have the experience and ability, shorting.

As to buying puts for protection as asked and ignoring more complex strategies, option premium is non linear so the cost per day is greatest for near term options and lowerfor far term options. Therefore, buying 3 month options four times a year will cost more on an annual basis than just buying a 12 month put.

OTOH, the protection level is fixed at the strike you buy so with a 12 month, you will not be protecting additional market gain if your portfolio value increases whereas with the 3 month options that cost more, you'll be stepping up your protection level every 3 months. The trade off here is cost versus degree of future protection.

I think that the only way to get a good feel for this is to see the numbers and that requires a little effort Set up a spreadsheet with the current value of the index you choose, say IWM and then "X" number of rows at lower prices at some increment you like Let's consider 12 month puts at 2.5 increments (if those strikes exist). IOW, with current price at 152.50, successive columns will be 150.00, 147.50, 145.00, down as far as you like. Determine how many puts you can buy at each strike with $2,000 and then assume that the market crashes and all puts are driven to parity. The rows will be the index price at lower levels. Determine protection gain below the each successful strike (# of puts times intrinsic value).

Do the same as above with 3 month puts ($500 spent) as well as 6 month puts ($1,000 spent).

Lastly, set up a spreadsheet with the value of your portfolio at 400k. If you used a 150p with the index at 152.50 then that is a 1.64% deductible before the puts kick in. Your loss will be 1.54% of your 400k plus the cost of the puts (assuming 100% correlation b/t portfolio and IWM). Do the same for other strikes.

If you wish, put all of this in one spreadsheet.

The short answer is that better protection costs more and has a lower deductible (loss of portfolio value). Poorer protection costs less but has a higher deductible. What you want to see is how well $2,000 protects you at different strikes as well as at different time periods (3, 6, 12 months). The answer may be acceptable. It may not be. The numbers will reveal hedge efficacy.

Clear as mud?

jimmyjazz · Dec 15, 2017

The short answer is that better protection costs more and has a lower deductible (loss of portfolio value). Poorer protection costs less but has a higher deductible. What you want to see is how well $2,000 protects you at different strikes as well as at different time periods (3, 6, 12 months). The answer may be acceptable. It may not be. The numbers will reveal hedge efficacy.
More...

So, what I said?

algofy · Dec 15, 2017

Wait, don't you realize the market doesn't go down.

spindr0 · Dec 15, 2017

jimmyjazz said:
So, what I said?
More...

Yep, once I got out my secret decoder ring and translated what you said, it was exactly what I wrote. Who woulda known?

DeltaRisk · Dec 16, 2017

spindr0 said:
Geez, this is a lot harder to describe than to just do. Hopefully this will make some sense.

A crash is different than a bear market. 1929 and 1987 were crashes. Unless you had some form of negative correlation protection in place prior to them, you took it on the chin. Bear markets like 2000 and 2008 took 18 months to unfold so they offered lots of time to react and adjust, namely transitioning to cash and if you have the experience and ability, shorting.

As to buying puts for protection as asked and ignoring more complex strategies, option premium is non linear so the cost per day is greatest for near term options and lowerfor far term options. Therefore, buying 3 month options four times a year will cost more on an annual basis than just buying a 12 month put.

OTOH, the protection level is fixed at the strike you buy so with a 12 month, you will not be protecting additional market gain if your portfolio value increases whereas with the 3 month options that cost more, you'll be stepping up your protection level every 3 months. The trade off here is cost versus degree of future protection.

I think that the only way to get a good feel for this is to see the numbers and that requires a little effort Set up a spreadsheet with the current value of the index you choose, say IWM and then "X" number of rows at lower prices at some increment you like Let's consider 12 month puts at 2.5 increments (if those strikes exist). IOW, with current price at 152.50, successive columns will be 150.00, 147.50, 145.00, down as far as you like. Determine how many puts you can buy at each strike with $2,000 and then assume that the market crashes and all puts are driven to parity. The rows will be the index price at lower levels. Determine protection gain below the each successful strike (# of puts times intrinsic value).

Do the same as above with 3 month puts ($500 spent) as well as 6 month puts ($1,000 spent).

Lastly, set up a spreadsheet with the value of your portfolio at 400k. If you used a 150p with the index at 152.50 then that is a 1.64% deductible before the puts kick in. Your loss will be 1.54% of your 400k plus the cost of the puts (assuming 100% correlation b/t portfolio and IWM). Do the same for other strikes.

If you wish, put all of this in one spreadsheet.

The short answer is that better protection costs more and has a lower deductible (loss of portfolio value). Poorer protection costs less but has a higher deductible. What you want to see is how well $2,000 protects you at different strikes as well as at different time periods (3, 6, 12 months). The answer may be acceptable. It may not be. The numbers will reveal hedge efficacy.

Clear as mud?
More...

Very smart. Historical volatility using Monte Carlo simulations can work, it’s just risk/reward quantifying versus a true edge.

This is one of the best additives I’ve read in a while, you’ll be helping the 2025 ET’ers also so thank you.

beefcaketrade · Dec 16, 2017

What are you long of?

just21 · Dec 16, 2017

Learn how to sell options in another market, if you have an interactive brokers account, you can sell options on futures. Then your long puts will be free. It is a modified risk reversal.