Hi guys, when should one pick options protection over futures for hedging on the downside? How do u decide which one is better? tks.
Each one has its pros and cons. Futures don't cost anything, but they hedge you both ways. Options offer more sophisticated ways to hedge, but there's a cost. There's always a trade off.
if you buy puts (or calls if you're short), you pay premium and can lose it if the underlying goes in your favor. That's the drawback. The advantage is that you participate in an upward movement if you get past a certain point in the underlying--the breakeven. long 1000 shares of SPY at 100 long 10 puts at 8.00 K=100 if SPY moves to 90, you lose 10 on SPY and gain 2 on the puts. Net loss of 8, instead of 10. At 85, you have the same 8 net loss on SPY, so you are capped on losses. As far as the upside, there is no cap there. SPY at 110, you lose 8 on puts and gain 10 on SPY, net gain of 2. SPY at 120, you have a net gain of 12. With futures, the hedge is close 1:1 if the notional amount is the same. You don't expose yourself to losses, but you don't get gains either. Unless you hedge 1/2 or 3/4 or x/y, then you have effectively sold the underlying while the future is in place.
I don't see how a future is a hedge (assuming the future underlying = whatever it is you're holding). Aren't you just exiting your position? Seems to me options are the only real hedge.
Imagine you hold a diversified portfolio of stocks, which has a high correlation to the S&P 500. If you want to get rid of the risk you have to sell the whole portfolio, which is very expensive and impractical and when you decide to get back in you have to reverse the whole thing. The futures allow you to get flat with a relatively low cost and in a single transaction, while still keeping your portfolio intact. So when you decide to reverse you just buy back the futures and that's it.
Murphy's Law states that your stocks suddenly acquire more beta on the downside though. Not relevant, but just one of those things.