Portfolio Insurance for Simpletons?

Discussion in 'Options' started by Funster, Jan 30, 2006.

  1. Funster



    I know that all of you on this thread are absolute genuises, so I wondered if you could point a mere simpleton in the right direction?

    I currently trade multiple underlying long stock positions and I would like to be able to, in an ideal world, purchase a put option, say once or twice a year, that gives me some kind of protection against total market downside.

    1. What is the most liquid options market for the total market? I figure that something tracking the wiltshire 5000 or nasdaq composite ought to suit, or even perhaps the russell 2000 as most of my trading is in small caps. I am lost whether to buy options on futures (a la CME) or indicies (CBOE) or ETFs (AMEX).There is just too much choice !

    2. I know that it is not this simple but is there a rule of thumb as regard leverage vs premium? For example does a put costing $4k roughly protect a portfolio valued at $100k. It seems to from my own calculations.

    3. Intutition tells me that I am best buying deep OTM puts to maxmise value in premium vs leverage. Am I right?

    4. As I am looking to buy with the longest periods as possible (i.e. to have less premium costs) the idea of LEAPS seems quite interesting to me. Is there anything I should watch out for here? (I suspect the downside being that they will be very expensive in terms of premium vs leverage).

    Many thanks for any help given

  2. First step is to analyze the make-up of your portfolio and determine what index would best be used to hedge it. For example, if you have mainly tech stocks, then you would look to NASDAQ puts in general, if you have mainly a large-cap broadbased portfolio then perhaps S&P puts, and if you have more small and mid-caps, then perhaps a Russel index put.

    So before getting to any of the more detailed responses, your first step is to do some self-study and determine what kind of portfolio you have in order to determine what kind of index will be best to hedge. Once you get that, then we can walk through how to determine hedge ratios (i.e. how many puts needed to hedge the $ value of your portfolio.)

  3. Funster


    Hi Optioncoach,

    Thanks for your reply,

    My portfolio is systematic and trades stocks across the entire market. It seems to have the large upsides of the small cap arena. That is why I thought Russell 2000 initially.

    However it also seems to have reasonably minimal downturns and has times where it it composed almost entirely of midcaps & some large, so S&P MidCap 400 seems more suitable here (because of its own limited downside during 2002).

    Perhaps if you can take me down a path for both those indicies, and I can either split between them or choose one of them later?
  4. Hello fellow hedge hog:

    A very good topic. You can base this hedge on:

    1. Magnitude and frequency of crashes from historical data
    2. Your own comfort and tolerance level
    3. Reduced downside volatility in the porfolio at a small price

    Say something crazy happens and your portfolio value gaps down 50% in the morning. If you proceed to curse someone in traffic and they kill you then your SPY puts are as good as real life insurance. How much do you spend on life insurance, home insurance, health insurance etc? Perhaps the SPY puts may at least be considered sanity insurance. A few hundred dollars a months is surely not much for this.

    So here is the procedure:

    1. Start out with 1% of net trading capital allocated to insurance in SPY puts. You could also use a spread as insurance using ES and SPX puts, which both have European exercise. In the spread, you would buy an OTM put and sell a lower OTM put to offset the cost of the put. If you understand option spreads, this is a pretty good either-way scenario, but you need a lot of initial margin for the short puts.

    2. Look at the prices for the OTM SPY (or ES, SPX) puts in longer-term months and see if you can afford them.

    3. If so, then estimate the net drop in your portfolio during a crash given the decrease in stock value and increase in the OTM put value.

    4. If you're not happy with the results, then just double the insurance and check your results again. Since you started with 1%, it's easy to use multiples of 2%, 2.5% etc. You can do all of this in an Excel spreadsheet.

    5. You can sell back the puts at an opportune time and roll up the puts [spread] so as to dynamically adjust the portfolio. This is somewhat of an art and takes experience.

    6. Overall, assess the investment in puts versus your likely (and tolerable) max loss and see if you are willing to tolerate the net anualized results.

    7. Another thing you may do is add long puts of stocks in weak sectors. During a crash, these may crash harder, all the while making you some extra cash in the meantime. Of course they may not, which is why it is usually favored to hedge with a highly correlated instrument.

    8. Another take is to hedge the portfolio with the SPY puts as you like, then use active trading income from option spreads to finance these puts.

    9. Having some UTH, OIH, XLE, and XAU long options may also help to offset the downside volatility of the portfolio.

    10. Check out Optioncoach's SPX Credit Spread Trader journal. This is the best play-by-play out there on how to dynamically adjust option spreads.

    11. After the VIX options are around for a few months, we may be able to implement these instead. We will see.

    When the market turns downward, volatility increases and OTM SPY or SPX options quickly spike in value. You'll need to examine the historical data to quantify these values. Look at a chart of the VIX to find suitable historic periods.

    Everythings seems peachy on paper. Take the time to trade small until you've developed the necessary finesse. I have only done this for a little while and would be happy to hear from someone with a few years experience. Best of luck and remember always

  5. Something worth considering is to use futures for the hedge instead of options. The most liquid equity futures are the (ES NQ and YM ... thats S&P N100 and Dow respectively) . These futures trade with very small spreads and their margin requirements are good enough to give you leverage that is every bit as high as what you get from a put option. If you want smallcap/midcap, there are russel and mid400 futures two but they arn't quite as liquid.
  6. 4k? 4% to protect the port from what, any loss below 96k? For a year.

    You tell me , assume thats correct, I haven't checked, is that cheap or not so cheap?
  7. Trading a married-put[synth long global call] or weak synth straddle via replication is not the answer. Everyone wants to game a perfect hedge, but nobody wants to pay to play.

    VBI/VIX options are not going to fly... the futures trade at a substantial contango, exacerbated by the long g/v on the options. In essence a horribly expensive var-swap. The VBI is not a delta-hedge. A slow, grind lower won't bring the VBI futures to life, but as a vega hedge they are suitable by design.

    1) Consider selling a risk-reversal. Buy an otm put, sell an otm call. Trade it via replication if you're aggressive -- selling otm NDX calls and buying otm SPX puts. Trading the pair will allow you to go two sigmas on the upside in NDX and one in SPX for very little outlay. Run these every expiration to trade gamma/vega. You do not want the vegas embedded in the back months -- trade a monthly rollover.

    2) Alternatively, buy the back month VBI futures -- one lot/$80k in equity at risk.
  8. Funster


    Thanks for all your replies / ideas. Obviously a more complex subject than I had bargained for!

    I was hoping just to buy a simple put option once or twice a year that would be, say, up 20% if my portfolio was down 20% (or thereabouts). The analogy to an insurance policy seems not quite accurate though!

    I do have a copy of Options Pure & Simple by Lenny Jordan. However I must confess I fell asleep after about 20 pages!

    I will dust it down and make an effort (to get to p100 anyway :) )

    By the way if I am going to have to get into this I do like quantitive figures rather than qualitative. I used Amibroker to backtest my portfolio to my own preferred confidence levels and now use some homegrown VB code in Excel to trade it. I am also fluent in Easylanguage & Wealthscript but they are S-L-O-W compared to AB for portfolio stuff.

    So what FULLY PROGRAMMABLE & FAST running software do you options guys use to backtest stuff like this & greeks (& where the heck do you get EOD data for all those strikes ?). I dont think reinventing the wheel using Excel is necessarily the answer!

    Thanks again

  9. Thanks Riskarb this is exc