I'm thinking of using straddles as portfolio protection. The idea is as following: With RUT currently at 592, sell a straddle with 2-3 strikes below the current price. For example, Feb. 570 straddle would give you downside protection of about 4%. The beauty here is that you are selling high IV, you have pretty good downside protection, but even if RUT reverses and goes up sharply, part of your loss will be offset by collapse in IV, and you might even make money. If your outlook is for bigger drop, sell even lower straddle. The general idea is to have protection, but buying it when IV is high, so compared to buyng puts for example, it's effective and not expensive.
There's something wrong with this picture. If you sell a straddle 2-3 strikes below current price to "protect a portfolio", effectively the ITM calls are covered by the portfolio but you've also sold naked puts which increases your downside risk. Got milk?
I understand that. The risk profile is similar to 570 calendar. Both have maximum profit at 570 and start losing money below 570. The difference is that straddle is vega negative and calendar is vega positive. When IV is high, you want to be vega negative, so if the underlying reverses, your position benefits from IV decrease.
My goal in general is hedging a long portfolio. Of course one option is to sell everything or using a collar. I don't want to do it. I want to use an unexpensive hedge. It has to protect me against 5-7% drop (assuming I already have a black swan protection), but if the market doesn't move or moves up a little bit, I don't want to lose money as well. If it moves up strongly, the loss in the hedge should be minimal and be more than offset by the long portfolio positions. Buying puts is not good, especially not now with high IV. Straddle might be a good option, maybe I should move it lower. Do you have other suggestions for a hedge that would suit my conditions?
slingshot hedge? (from Charles Cottle) Long stock, short 2 call verticals, use those to finance long put (basically a butterfly with an extra OTM call) market moves down, protected by long put market sits still, profit from decay of short call verticals market moves up moderately, you lose money, market rallies, you make money tradeoff is you reduce your delta, but you can roll the position around based on what the market is doing... that way you get downside protection and the upside too
Sure want to do that? You are ITM short call. Adverse price move can easily crush your gain in volatility.
Hmmm, interesting idea. My first reaction is that at higher IV, it's not going to work that well. In terms of IV, with verticals, whatever you receive for the call sold you somewhat pay for the call bought. As IV gets higher, the net premium received increases but not dramatically. There's a bit of an offset. OTOH, the cost of the protective long put skyrockets as IV increases. The higher the IV, the more the cost of the entire hedge is going to be and the less attractive the hedge will be. There could be a decent loss if the underlying just sits there. You could somewhat improve the performance in the area around the current UL price by selling a vetrtcal one strike higher but it wouldn't help the hedge much overall.
Never thought of it that way... Do you mean higher relative IV? Or when IV is inflated due to news announcement?