What is the best option hedge for the Dow mini, or the Dow itself for that matter, against a sudden huge black swan price change event?
Stop orders? If you have too much fear that the Dow will plunge, why not just sell? Buying puts (or similar strategies) dramatically reduces your profits. As a retail investor you don't need to hedge. Mutual funds hedge during uncertainty because they just can't sell everything and remain in cash; because of legal regulations, buy you -a retail investor- CAN sell.
I'm not so sure I can sell.... Bigger traders can buy seats on the CBOT and be assured that their orders will go to the head of the line, my stop market order might get filled far away from where I need it to and my stop limit might have it's stop price passed over in a real panic. When the YM goes over to Oanda stops won't be exchange resident, that is a big factor in stops in the panic situation, whether they are exchange resident or residing on my machine or with the brokerage.... I'm looking for a hedge method and then I want to see what it costs me. Having an option hedge in place would give me one less thing to think about.. anybody?? I know it exists, a non directional hedge against volatility, I'm an intraday YM trader and I know nothing at all about options... I'm visiting the full service broker my wife uses this afternoon, I would ask them but they will try to sell me something I don't really need most likely...
I'd suggest some deep OTM puts, probably on the DIA. Otherwise if you are unsure about the direction of the price move, I would recommend a long strangle.
The rule of thumb I have always heard is that it costs about 3% of your portfolio to hedge it. I ran a portfolio containing only 716 shares of the Diamonds (the Dow ETF) which has a value of $100,000 through my hedgefinder using the cash-settled djx options (using a time frame out to the June 2008 expiration). When asked to keep look for a hedge that would result in no more than a 10% loss (no matter how far the Dow dropped), it recommended buying 8 of the June '08 128 djx puts for a total cost of $3,120 (or about 3.1% of your portfolio). When asked to keep losses to no more than 5%, it recommended buying 8 of the June '08 133 djx puts for a total cost of $4,000 (or about 4% of your portfolio). Do this and you can't lost too much. Of course if the Dow goes up, you only receive the % gain minus the cost of the hedge. That is why most individuals (and fund managers as well by the way) would not do this - They can't, or are unwilling to, take the chance they would underperform the market.
Yikes. Paying 4% to limit your losses to 5%? That's crazynuts. What is the position you are hedging? A straight long portfolio? Something like a vertical spread or ratio spread instead of plain old shares will give you decent upside returns with limited downside risk. In the end, there is always a price range where you will lose money, and the idea is to use options to put that range where you think the underlying won't go. The lower your potential loss, the greater the probability that it will be realized (i.e. wider price range corresponding to that loss). See, for example, the hedge against losing 5%. You start out down 4% already, so if your main portfolio drops just 1% you have bottomed. You'll have to appreciate 4% just to break even. There is no way to enjoy the full upside potential risk-free without paying dearly for insurance. As Stephen Colbert would say, "pick a side - we're at war".
3% of initial margin is a whole 19 YM points per contract. If I don't make that in the first hour every day I feel bad... I assume one has to trade the options as the price moves to keep the non directional bracket comfortably placed somewhat equidistant away from the price... worth it to me, I hate worrying about the Black Swan events, I've seen guys that were psychologically and economically devestated by such.. one of them walked around the workplace holding onto the walls, he really would go down the halls with his hands on the walls, and he could not talk to anybody for weeks after 1987, up until that time he was on the phone to his broker all day every day and talking about his huge expansion plans for his house.... another one sat alone crying with the printout of his portfolio, every day, for weeks after the 2000 nasdaq crash... hee hee, options cost a little, not a problem, better to pay up the insurance and sleep well....
To hedge mini dow (YM) do five DIA options for every YM contract you own. That is if you want a 1 to 1 ratio hedge.