Question about hedging a portfolio

Discussion in 'Options' started by hedgeme1, Jan 29, 2004.

  1. hedgeme1


    I have a strategy that basically trades ES futures as well as some equities in multi-day to weekly trades, utilizing both directions throughout the week. My concern is a sudden drastic move in the market (gap up or down intra day or overnight) due to world events or major news. 9-11 as an example as far as catastrophic events and being long at that time. That's only an example, as I simply want to limit my exposure not knowing the future. What I am trying to do is design an options strategy that can basically be put on for a period of time as a blanket protecting from the unknown and at the same time limit my costs, as I know it will cost me for this type of insurance, but I am willing to pay for it as long as my profits eventually overcome these costs obviously. I have looked at protective collars and straddles and I was looking for some opinions. It's not for a ton of money, so lets say 70k is the portfolio. Also I have been thinking about readjusting the options positions as the market drifts to keep the positions in check. Again, all I want to do is have a "protective" band around my portfolio to stop major risk and at the same time, not kill too much of my profits. Some possible scenarios are a partial hedge if the costs are higher than expected. Also, I want to hold these options positions for a week or so to hopefully limit transaction costs of no adjustments are necessary. Any opinions would be greatly appreciated.
  2. I once had a boss that I respected a great deal back in my first job out of college. I came to him rather puzzled one day with a difficult work-related problem that I did not yet know how to solve. He told me this, and I never forgot it:

    "Don't come to me with a problem. Come to me with a problem, three solutions and a recommendation."

    All you've done is post a general problem on how to hedge an unspecified 70k portfolio of stocks and futures. Using options to hedge is perfectly viable, but you need to frame the question with enough specifics so that people here can actually attempt to answer it.

  3. hedgeme1


    You are correct. My apoligies. Well, I guess lets just keep the strategy a little more simple than it really is for the purpose of this example. Lets say my strategy goes long and short the ES for 10 contracts with holding periods of weekly to multi-day. No bias to direction at all. You could be in both directions during the week, or simply be in one direction for the week. Basically moving average style trading. I want to hedge or partially hedge that position (either direction I am in) against catastrophic moves against me, while keeping the costs of the "insurance" down. Average wins range from 3 points to 10 points.
  4. 10 ES on a 70k account is leveraged 8-fold. You are going to find it expensive to hedge against catastrophic risk with that leverage IMO.

    What is your maximum acceptable drawdown in a shock news situation? If it's 50% i.e. $35k, then that allows 70 ES points per contract.

    The March 1060 puts are 8.5 offered, 1200 calls are 3.6 offered, total cost 12.1 x $50 x 10 lots = $6050. That is for about 7-8 weeks protection, so for an entire year you would be looking at maybe 7 times that amount i.e. just over $40k per annum. Then you have to add on the cost of moving the option strikes when the market has a big move - I'd estimate you going to be paying maybe 0.5-1 points per "adjustment" (better to ask a regular options trader for the cost of this), and maybe adjust say 1-3 times during the life of the option? That might add another $5k to the annual cost.

    Remember, this is during a low volatility environment. If you had a 9/11 situation, then vol would soar, and you would have to reset your strangle at a massively higher cost

    So you need to make about 65% a year just to cover your options premiums. Check your returns and see if that is affordable.
  5. Well, even a 5% move against you will knock 1/3 of your account out of the box (50 points @ $50/pt per contract @ 10 contracts is $25,000). Your size is way too large. Why are you using so much gearing? Anyone here will tell you it's a recipe for disaster.

  6. hedgeme1


    Yeah, I am aware of the numbers. I realize it couldn't add up in that fashion. I am just trying to get thinking about different strategies and the costs associated with them.
  7. ktm


    How about this.

    Today we are at SPX 1130. Let's say you are long. Sell the Feb 1150C for $6 and buy the Feb 1100P for $6. It's a free trade at that point, but not as the market moves.

    Up to 1150, you make a good bit on your ES, lose the P $$$ and are on the hook for the 1150C, which will be more expensive to close out. That should be more than offset by your gains in the ES due to the Delta on the 1150C being less than one. You could - by using futs opts - leave the ITM ES futures alone and let them get called away at expiration above 1150, thus limiting your upside gains to 20.

    The same could work to the downside, but the VIX explosion could get in the way of selling downside puts if we have panic news. I would suggest a slightly different strategy for the short side. I would also play with the ratios on each side - don't necessarily sell and buy 10 of each side etc... Close them out in phases, etc... I would put together an Excel sheet and use the CBOE volatility calculator to play with some scenarios and do some backtesting. If your directional trading is successful, you should be able to add a layer of protection and possibly enhance the profitability by using options.
  8. hedgeme1


    That's great info and very much appreciated! Downside risk is my major concern. Basically the overnight longs into a weekend that stoplosses will not get you out of and the mkt opens 50 points lower.