Different Hedging Strategies

Discussion in 'Strategy Development' started by sbs17, Mar 15, 2006.

  1. sbs17


    I'd like to generate some discussion on different ways to hedge a portfolio.

    It seems that using options is one route to go. For example. I could buy puts on the qqqq. If the qqqq is trading at 41.60 and I buy a June 41 put for .90, I limit my risk if the market drops below 41. However, lets say it is one month later and the qqqq is now at 44. I still have my June 41 put, but now if the market were to drop 10% to about 40, I wouldn't be protected, because my put is a 41 put. What are other options?

  2. The correct analysis is that you are still protected, but not from the 41-44 range. The easiest thing to do would be to just buy more higher strike puts to protect the upside you have just gained. You could just sell off the 41 puts at the current market price (taking a smaller loss than just letting them expire worthless) and rolling in to the higher put, or you could establish a put spread at little to no cost, or even a credit if desired.

    Of course established analysis skills would have to be used in order to create the appropriate hedge and risk profile. If you were pretty confident that the security (QQQQ in this example) is range bound or upward biased, then you could sell puts at the 41 strike and purchase 44 strike puts with the proceeds. You would stand to make a profit on this position as long as the QQQQ ended up between the 41-44 strikes. The naked 41 puts would expire worthless and the 44 strike puts would have offset any losses experienced in the stock.

    This is a very widely used strategy and is listed in most options books. A put ratio spread could be used to establish some downward insurance at no cost or for a credit even.

    Just a couple of thoughts. Good Luck.
  3. sbs17


    Thanks for the reply Algorithm.

    I was looking into different strategies more for hedging against an entire portfolio than for making outright trades. The way I see it, if I buy 41 puts on the qqqq, and then the price moves up to 44, then my portfolio is no longer hedged against downside risk, as I want it to be. I could sell the 41 puts and buy the 44 puts but I won't get much for the 41's. It seems that to be hedged against risk, you have to constantly adjust your puts up as the market rises. This gets to be expensive.

    There must be alternatives. I have heard that one can hedge with futures. Does anyone have a strategy they wish to share?
  4. Hedging a long portfolio of stocks is neither simple nor cheap. If you want to hedge one stock, such as QQQQ, then you can eliminate the problem of the hedge not tracking your portfolio perfectly. Or maybe you don;t care if it is a perfect hedge.

    The expense issue can be handled in various ways, but the fundamental law of options is that there is no free lunch. If you buy short dated puts, they lose value quickly as they approach expiration. If you buy puts that are several strikes out of the money and thus cheaper, you need to buy many more of them than the equivalent number of shares being hedged, because their delta is low. If you go out several months to minimize loss of time value, theta, thne you run the risk that the stock moves so far away from your strike that your hedge is ineffective. Also, the options can lose IV and actualy lose value even as the stock declines, although that would be unusual.

    One approach is to sell out of the money calls and use the proceeds to buy puts. This is called a collar. The problem is you also give up any upside beyond teh calls' strike. Cottle teaches a hedge he calls the sling shot. You sell several call vertical spreads and use the proceeds to buy puts. Then you at least will profit on a move beyond the short calls' strike.

    You could use futures to hedge an index. Since being short a future is the synthetic equivalent of being long a put and short a call, the effect is identical to a collar.

    There are many variations involving options. I suggest you look at Charles Cottle's book, Coulda Woulda Shoulda.
  5. The best nuclear-hedge is a back-month bear, risk-reversal. Long downside vegas. >tenor = >vol-sensitivity. Calc the one-year atm straddle premium and trade strikes just outside of the straddle premium[2sigmas]. You'll need to sell some deltas to maintain a zero-cost collar on your long equity positions.

    The Dec06 1200/1400 outside bear reversal is trading:

    Dec 1200p = 1900
    Dec 1400c = 2700 . . . . . (800) to the sell

    You're getting paid 800 to hold puts. Granted, you're getting hurt on hedge above 1400, but giving up a little on the upside is a small price to pay for peace of mind.

    I buy a one-lot, one year bear-reversal on every 10 point rally in the SPX. Do not buy a bear reversal[bull reversal] into a decline[advance].
  6. There was a recent discussion about hedging against a powerful intraday move


    I think that hedging by having short positions as well as long positions (market-neutral) is a more natural and effective way to hedge...keep the portfolio dollar-neutral if you have $1000 in long positions, then take $1000 in short positions too to balance. You would have to deal with issues related to shorting, like locating stock to borrow, potential to get called in, uptick rule etc..
  7. sbs17


    AAA - Those are all great ideas. Thanks for the info. I hope to take a look at the book you mentioned.

    RiskArb - I'm not THAT familiar with the options lingo so I fail to comprehend what you are saying, but thanks nonetheless.

    Gigollo - The market nuetral portfolio is one route to go, but by doing so you also commit half of your capital to shorting stocks. If you want to have a long portfolio and just by insurance, that seems a very expensive route to take.
  8. sbs17


    Has anyone ever tried hedging with really weak stocks, rather than using an index?
  9. Yes, why would you be interested in having a long-only portfolio? Theoretically, u can have longs and shorts in the portfolio and thus be more balanced and decrease volatility in your portfolio. That requires you to be able to play both sides of the market though a skill that is presumably more difficult than trading from one side
  10. sbs17


    By having half your portfolio on the short side aren't you putting yourself at a disadvantage since the markets tend to rise in price overall?
    #10     Mar 18, 2006