Firstly let me say I'm a futures trader so my knowledge of options is fairly basic. Hence, I have come to you wise people for your opinions. As a conscientious and risk adverse futures day trader (if that's not a complete contradiction in terms) I am always concerned with the possibility of liquidity suddenly drying up and price racing away, leaving me unable to get out of a position. I know that given enough time this possibility will become a certainty...it's just a matter of when... My trading methodology allows me to know very quickly when I've made a bad entry and hence I can trade with very tight entry stops (typically 4-6 ticks). However, given the danger of overleveraging, I only ever put on an absolute maximum of 1% of my trading capital at any time. This reduces the risk of a runaway 50+ tick move completely cleaning out my account. I also make sure I am flat going into any big scheduled news announcements (interest rate decisions etc). I've started thinking recently that I should be employing options to properly hedge my exposure. Initially I looked at maintaining a hedging options position at the nearest OTM strike to my futures entry price. E.g. If buying 15 lots at 1.4691 in the futures market, then hedge the position by buying 15 puts at the nearest OTM strike (1.4650). If closing the futures position then close the hedging options position. However, having done some rough calculations I quickly realised that, everything else aside, just paying the options commissions and spread every time would kill me... So I started thinking instead about setting up a full bi-directional hedge at the beginning of each trading day and keeping it in place until the close of the trading day. This would save on commissions and spread. The obvious hedging position is a long strangle. I'd adjust the strangle during the course of the day to keep both the calls and puts OTM. In maintaining the strangle the gains from selling the options which have drifted ITM should offset the losses incurred by selling the opposing options which have drifted further OTM. Considering the Greeks: Theta: Since I'm only holding the position for the duration of the trading day then time decay shouldn't really hit me too hard in the pocket. Vega: Given that this hedging position will really only come into play in the event of explosive volatility in the underlying futures market, this should work in my favour, pushing up the value of both the call and put options. Delta/Gamma: This is where I start to come a bit unstuck and my understanding of options lets me down. I believe that ATM options tend to have deltas of ~50, so in order to fully hedge my maximum futures position of 1% should I be taking a options position equal to 2%? As I said, I'm not an options trader so please don't hammer me into the floor if I've got something fundamentally wrong. I'm just looking for the most robust (and obviously cheapest) way of protecting myself against explosive moves in the underlying. Any thoughts on this would be really appreciated.
You didn't say what you're trading, although the quote looks like eur/usd. In any case, here's my problem with what you propose. Quite aside from any greek considerations, if there's a problem with liquidity in the futures contract you're trading, that will only be worse with the options. Setting up a "safety net" such as you propose would still cost you most days just on the bid/ask spread, even if nothing else changes. On wild days where you really need it, if you get out at the end of the day you'll find that the bid/ask spread has widened, perhaps significantly, so you won't make as much as you "should." In other words, buying such insurance on a daily routine basis sounds to me like a significant expense hard to overcome with trading profits. And when you really need it I suspect you'll find it's not as much protection as you thought it would be.
Thanks for your reply dmo. I trade all the reasonably liquid futures contracts but for reasons I won't go into here I have a particular love of currencies. I take your point about liquidity in the options market mirroring liquidity in the underlying futures market, but the whole purpose of this hedging strategy is that it is put in place before any potential liquidity dry up. The sole purpose of this insurance would be to cover (maybe not completely) the horrendous slippage I'd incur in a 6 sigma event when exiting my futures position. I wouldn't be looking to hold the options position any longer than the futures position...after all it's a hedge, I'm not intending to use it for speculation at all. Like all insurance, I'm aware that it's going to cost me (possibly significantly) but when one of these events occurs it's potentially the difference between taking a 10% hit if I am insured and a 50%+ hit if I'm not. The intraday charts for Black Monday still have the capacity to scare the living shit out of me.
The best way to "hedge" yourself are through things like: -- diversify your position. If you trade currency futures, consider metals, energies, meats, grains, softs, etc. Falling in love with one class leads to more exposure when things hit the fan. -- try to be out before announcements that might hammer the instruments you trade -- trade volatility - (when higher, trade smaller). In fact, the higher your leverage, the higher your "risk of ruin." -- divide yourself. Maybe hedge 1/3-1/2 of your position, but as people said above, costs are a serious factor. -- if the kind of event you fear is a market disaster, then maybe you should consider holding 10% of your account in gold-related ETFs. They TEND to rise in value when a crisis hits. Just hold it longterm, as an economic crisis insurance. IT may go down, it may go up. But again, insurance always has a price and a risk -- ensure you ALWAYS have a real DISASTER stop in place. -- Interactivebrokers lets you keep your account in a different currency (I think Euros, Swiss Francs, etc.). It is one way to protect against the dollar. Buying "insurance" when trading can take a serious slice out of the modest profit that some traders manage to make.
If you expect horrendous slippage when exiting your futures position in such an event, why do you think there will be less slippage when concurrently exiting your options position?
I didn't say I'd exit the futures position. If the slippage is so extreme that my marketable limit order to exit the futures position didn't get filled, I wouldn't chase the price...I'd leave the futures position open. This is when the options should move ITM and start to offset the futures losses. I think people may have got the wrong end of the stick here. I am not talking about entering or exiting either the futures or options positions when the market is in a complete mess and there's no liquidity. That would completely defeat the whole purpose of this hedge...it's entire reason for being is to allow me to avoid paying horrific slippage costs, not to double up on them. I'd take off both the futures and options positions once enough liquidity has returned.
TraderZones, Firstly, let me say that I am grateful to everyone who replies to my threads. I didn't mean to be rude. However, your answers suggest you didn't read what I posted. I'll address your points using quotes from my earlier posts. 'I trade all the reasonably liquid futures contracts...' 'I also make sure I am flat going into any big scheduled news announcements (interest rate decisions etc).' '...given the danger of overleveraging, I only ever put on an absolute maximum of 1% of my trading capital at any time.' I'm looking to 'fully hedge my maximum futures position of 1%'. I'm a 'futures day trader'. 10% of my account in a gold ETF would not even come close to providing an adequate hedge. 'I can trade with very tight entry stops (typically 4-6 ticks).' Valid point. My account is in GBP. However, choice of currency denomination isn't much of a hedge as any currency is capable of collapse. Admittedly some are currently weaker than others though... I do appreciate your input TraderZones and if the thread was 40 pages long then I could understand you not reading it all and missing some points, but 2 pages!?!?