Using Options for Crash Insurance

I trade futures (mostly ES and ER E-minis) and tend to hold positions overnight and on weekends. As a result, I’m concerned about the impact of some major piece of news that might occur when I’m asleep, or when the market is closed on a weekend. (think of what would happen to US markets if someone sets off a nuclear device in London overnight, just to pick one of zillions of nasty possibilities)

Up to now, my trading has been fairly small in scale, and my protection has been limited to stop orders, which would be pretty useless in a situation like I’m thinking of. As I scale up my trading, the need for effective protection becomes more important.

I’m basically thinking of buying way OTM puts (one per contract) to provide a type of crash insurance. I’m looking at puts that are about 10% down from the market. If you are willing to buy these with about a month left before expiry, they don’t seem too expensive. For example, I paid 2.2 points on a March 625 put on the ER mini this morning. If I do six trades over the next month, averaging 6 points profit each, that level of protection would cost me about 6% of my total profits, which seems reasonable.

Of course, this type of insurance has a high deductible – I’ve got to be willing to absorb the first 10% of any crash. So again using the ER contract, that’s a 70-point hit, or $7,000/E-mini. The margins in my account can handle that OK, it’s the next 10% (or more) that I worry about. That’s where the puts would come in, of course.

I’ll probably trade short positions “naked”, as I’m not so worried about a gigantic sudden move in the up direction, specially if the US markets aren’t open.

While I could sell back the puts whenever I go short, I don’t think I’ll do that. The spreads on these are kind of high, and I think it’s easier to just buy them and hold them until they expire. In addition, it’s very hard to buy these after hours, when I usually do my trading in the underlying contracts.

So that’s my current thinking on crash insurance. Any suggestions for changes and/or alternative approaches would be welcome.

 

1) Don't carry any positions over the weekend.
2) Don't carry overnight positions if you're having trouble falling asleep.
3) Reduce your position size. If your position size is 1-lot, get more money into your account.
4) Instead of buying (DOTM) deep-out-of-the-money put options, consider doing a put-backspread initiated at breakeven-or-better that isn't as far out-of-the-money. It may provide a better return/risk profile for your liking.

 

at least buy long-term puts, just divide the price of 12-month options by 12 - they will be much cheaper than 1-month puts. Long-term puts also will contain time value longer - so you'll probably make a better deal at closing, especially if you close the position way before expiration.

 

That's probably only worthwhile if you want protection at the same strike price for several months. Great if the market is trending down, but bad if the market is trending up and you have to keep rolling your put up at a loss because it offers less protection as it gets farther from the money.

 

Of course your positions should have some level of loss limitation.

However; wholesale institutions make a load of premium by selling options like the one you are describing. Given their size, it costs them very little to write contracts that are *according to their models* highly unlikely to expire ITM. Insurance companies make a load of premium by underwriting against unlikely *more accurately, mis-priced* events. Actuaries make a living out of it!

Buying an option, or insurance, will usually put you on the wrong side of this deal.

DO PROTECT YOUR POSITIONS AGAINST EVENT LOSSES!

just try and do it for free.

 

I agree, nothing was said about time of the position hold.
but anyways with short-term puts you're more likely to pay the insurance premium in full. With long-term puts you'll most likely roll forward at a relatively small debit.

 

I'm not sure I understand this. If you mean something like selling a 650 put and using the proceeds to buy two 630 puts, how do I handle the case where the price drops to something like 640? At that point, couldn't I be assigned the contract? Not what I'd want to see happen in that environment. And my 630 puts are still OTM.

Maybe I'm missing something here?

 

OK, I'm all for that, but how? (see my other post above)

Often what you get for free is worth what you pay for it... is there an exception here?

 

1) You're missing something a few things.
2) You can reasonably expect the the 2 long-630-puts to outperform the 1 short-650-put. The volatility curve should steepen making the 630's more valuable with respect to the 650's.
3) Early assignment is generally advantageous for the short-seller. If put premiums explode during a 10% downmove, the holder of the 650-put would be wise to offset instead of exercise the position.
4) Your 630 puts may be out-of-the-money but they'll become more actively traded and you can use them to complement other strategies.

 

Nazzdack,

Thanks for the clarification. I hadn't thought of the volatility curve steepening, and I agree that the 630's would be more tradeable.

I don't quite follow this part:

Why is early assignment advantageous for the short seller? And why do you say the holder of the 650 put would be wise to offset instead of exercise?

I'm not disagreeing with you, I'm just trying to get educated as to the logic here.