Quote from giggollo: If you buy some puts a few levels out of the money (yes enough so it doesnt hurt your upside) and the whole market tanks 50%, why wouldnt your put options be worth a lot, enough to offset 50% losses on your long stock positions?... They would. But entire markets (well, not the largest markets anyway) don't move 50%. They move 5-10%. I thought about continuously having a S&P Put position that was close enough to matter (i.e. react to a 5-10% move), but as others have said, it's way too expensive, considering how seldom it would have done any good in the last 20 years.
Well, dont the puts give me the right to exercise sale of the underlying at a certain higher price, so i still have the right to exercise (rather than sell which requires liquidity) and the option writer has an obligation to be on the other end of that transaction (options clearing firm i presume)..if ur saying options clearing firm will collapse thats another story..is that possible? then there would be no point in hedging to begin with!
ok, were not talking about hedging against a 5-10% event that might occur a few times per decade, were talking about a once in a lifetime massive event similar to 1987, and whose magnitude is unknown until it happens...1987 markets plunged over 20%...and until now people cant find a "logical explanation" http://www.lope.ca/markets/1987crash/events.html ..what if there was a real reason, like a major geopolitical or financial disaster, do you think markets cant drop more than that?
We had a major geopolitical disaster the morning of 9/11/2001, while the futures and ECNs were open (and remained open for quite some time). Even if, God forbid, a nuke or a bio-bomb were detonated on Wall Street***, it would not cut equity markets in half when they re-opened. All listed companies are not suddenly worth half what they were before. I would expect an initial reaction of the same magnitude as 9/17/2001. Some might even say it would be smaller, given that many understand and expect it. Remember that we're talking about intra-day hedges, too. It seems that you're trying to inject longer-term ideas (like "never recover"). The idea is simply to be able to hedge a large decline in equity positions until a liquid equity market returns. Looking at it from another perspective, I believe that if an event were to occur which could cut our equity markets by 50%, puts would be little protection, as I would expect wholesale failures of clearinghouses, massive currency and debt valuation moves, etc. Such an event would probably give most people problems that greatly overshadow any portfolio issues. ***If anyone is offended by this hypothetical, I apologize.
In 1929 and 1987 too many people were highly leveraged on the long side. All went up for 3 or more years and stops were rarely used. So when the market dipped a little, a few got margin calls - their positions were closed to sqeeze the next less leveraged into mc etc producing -20%, that was supposed to be -5%. It could have dropped to -50% just because of margin calls.
I've read it was margin calls in March 2000 that dropped the Nasdaq 30% in a few weeks. Not sure since it wasn't my margin calls but it seems reasonable.... Not much you can do in that case....except not get in the position in the first place :eek:
Well actually i was not thinking of holding on for liquid equity markets to return. In my original question i actually was wondering about highly leveraged traders in particular. As was mentioned in the above posts, margin calls may force you or firms holding your positions to liquidate them at severe losses especially if ur leveraged. I dont think youll have the luxury of holding on to them until the markets recover. Hence the need to be hedged for this type of rare event. The more leverage u use, theoretically, the more u need to think about this it seems to me..
I'm not aware of any major index that has ever "tanked" 50% INTRADAY. It seems to me that you are speaking with little to no sense of realism. An SPX March 1200 put for example at the close today was offered at 2.15 with the SPX at 1275.53. So what you are proposing is to risk 2.15 for one month approximately, on an option that is about 6% out of the money. So if you are long some index futures how many of these puts are you going to buy per contract as an "intraday" hedge? Keep in mind, you lose 75 points X $50 on a futures contract that drops to 1200. That's $3750 per $59,000 contract in the S&P that you risk before you "hedge" ever has a chance to "kick in". But at 1200 on the 3rd Friday of March your put is worth zip at 1200. Again, you tell me, how many of these are you going to buy as your hedge? What I figure is that each year you lose $2580 per each put you buy provided this "intraday crash" you fear has not taken place. If the SPX would have to move to 1125 for your 1200 put to be worth $75 to offset your loss on the S&P futures, mini contracts. At that point you would have lost $7500 per contract of futures, and gained $7500 per put. That's a move of somewhat over 10% for you to be even. IF that move does not take place again, you lose $2580 per year. There are other puts that you could buy. In order to cut the loss down you have to move farther out of the money. You could buy more puts, understanding though that it is all a loss unless this disaster you fear actually takes place. And finally understand that your original post used an INTRADAY context. We have limits on futures and in the move the stock market can make intraday. You might want to take a look at those before you proceed. OldTrader
Thanks for your input, OldTrader. With full respect to your opinion, i think that just because something never happened in the past doesnt mean it cannot happen in the future. Maybe other people can also voice their opinion on this. What is your suggestion for highly leveraged traders who may suffer large losses or get wiped out due to being highly leveraged in a smaller, say -10% , intraday drop in the market? Can they hedge against it in a effective way, and if so, how?