Less Costly Method: Hedging with put options

I’ve joined the impressive group of writers who publish their thoughts at the new CBOE blog


The following excerpts comes from a recent post by the (Surly Trader)

Put Spreads as an Attractive Hedge

Hedging equity positions [with puts] can be fairly expensive, but there are very attractive ways to mitigate that cost.

Bearish Diagonal Put Spread

I like the (bearish/reverse?) diagonal put spread strategy for a number of reasons: [MDW: I would call it ‘reverse’]

I am purchasing implied volatility at much lower levels by buying the short dated put, making the short dated downside protection fairly inexpensive.

I am selling implied volatility that not only takes advantage of the steep skew, but also takes advantage of the fact that longer dated options are trading at higher implied volatilities than short dated options.

I hope this brings some new ideas to your option trading strategies.

My all-time favorite hedge is one step removed from here – a bearish ratio diagonal put spread in which I buy short dated put options and sell a larger number of far out of the money longer dated put options….

He (ST) is advocating buying a front-month, less expensive, put option and selling extra longer-term, farther OTM puts. Two points:

  • Less expensive because it is front month an d has much less time value (obviously), but also
  • Less expensive because it has a higher strike price and thus a lower (becasue of skew) implied volatility

    I like part of this plan, but prefer not to sell naked options.

      Example, Surly Trader’s play may be:

        XYX is trading ~520 to 540

        Buy 10 XYZ Jun 500 P
        Sell 30 XYX Nov 420 P

    I’ve previously written about a similar plan. It’s the coward’s version. He sells naked options and I sell option spreads. But we both suggest owning the short-dated options. I encouraged that idea as a risk management method for adjusting iron condor positions in The Rookie’s Guide to Options.

    In the coward’s version, I sell 30 or 40 put spreads (vs.10 puts bought): It’s not easy to know which strikes because so much depends on IV. Yet a reasonable guess is the 420/430 P spread or the 430/440s.

    If the market makes a steep decline, My long put will prove to be very profitable – perhaps explosively so due to a much larger IV increase (as measured by IV points, not in $) in the front month options . This represents a situation in which positive gamma becomes our ally – and there is no worry about fighting negative gamma.

    The shorts are spreads, with limited losses. Profitability for the whole trade depends more on how far the market moves and how much time remains in our long options (time value can be significant, even during the last few days prior to expiration) than on the price of the short spreads.

    This reverse ratio diagonal spread produces favorable results when:

    • Rally occurs with volatility decline. Longs expire, Cover shorts cheaply
    • Large, rapid decline
    • Time passes, longs expire, but shorts decline by enough to turn the whole position profitable. This is the result of owning cheap Jun options (and not costly Nov options) as protection against the Nov shorts

    This trade is uncomfortable for many traders because they know must buy new protection, or exit the trade.

    Despite the apparent ‘backwardness’ of this trade, at times it can be the best choice – if not as a stand alone trade, then as an adjustment for a credit spread gone awry. I would not make this my strategy of choice. But it has enough going for it that it is always a consideration. And it is ST’s favorite.

    959

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8 Responses to Less Costly Method: Hedging with put options

  1. AP 05/02/2011 at 9:54 AM #

    A good strategy, but not for people with RegT margin. Only suitable for portfolio margin accounts, Correct?

    • Mark D Wolfinger 05/02/2011 at 9:57 AM #

      AP,

      If you sell SPREADS, then reg T is not any more of a problem than usual.

      However, selling single options that expire after your longs is a big problem with Reg T margin. And selling extra naked options is an even larger problem with Reg T.

      Thank you for adding this important point.

  2. Rower32 05/02/2011 at 4:19 PM #

    Mark I’m little confused with the terminology here, please help me. When you say selling put spreads you sell 430 and buy 420, right??!

    • Mark D Wolfinger 05/02/2011 at 5:36 PM #

      Yes Rower.
      Most people learn to use long names to describe a spread:

      sell a bear put spread – for example.

      I prefer simplicity. We either buy or sell a spread.
      I define the spread as follows:
      If you BUY the spread, you pay a debit and buy the more costly option
      If you SELL the spread you collect a cash credit and sell the more expensive options

      I hope that is not confusing because I am trying to eliminate confusion.

      Regards

  3. WY 05/05/2011 at 1:41 AM #

    Hi Mark,

    Any chance of clarifying the statement below

    •Less expensive because it has a higher strike price and thus a lower (becasue of skew) implied volatility

    Why is the purchased put less expensive with a higher strike price? Thought a put with a higher strike price should be more expensive compared with one with a lower strike price, all other things being equal?

    • Mark D Wolfinger 05/05/2011 at 8:30 AM #

      WY,

      Yes, the put with the higher strike price costs more. Always. Unless the bis is zero.

      However, it trades with a lower implied volatility. And that lower implied volatility makes the put ‘less expensive’ from a ‘value’ perspective. Another way to say it is that the put is less ‘expensive’ because you get better value for your dollar. The lower strike price put option has a built-in surcharge – and avoiding that surcharge makes the higher strike price option less over-valued.

      In options trading, the term ‘less expensive’ is often applied to the option with the lower implied volatility. That IV is how we measure ‘expensive’ and ‘cheap’ options. It is not in the absolute cost of the option. The term is that the higher strike put is really ‘relatively less expensive.’ But it is seldom necessary to use those extra words.

      Does that explanation work for you?

      Regards

  4. WY 05/06/2011 at 12:55 AM #

    Thanks, Mark. I got it. So the put with a higher exercise price is cheaper in relative rather than absolute terms and it may be more worthwhile to consider this put than one with a lower strike price from a value perspective. I am still trying to understand volatility skew better though.

    • Mark D Wolfinger 05/06/2011 at 7:00 AM #

      WY,
      Mastering the concept of volatility skew probably has its benefits. And if you Google the topic I’m sure you will discover worthwhile discussions.
      From a practical consideration, learn whether your broker shows the current implied volatility for each option that you are thinking about trading. That way you can see the IV of the options that you trade. But I have a warning: Skew exists, so please don’t always look to buy the option with a higher strike price just to pay a lower IV.

      That may work well in some strategies – perhaps a collar or choosing a put for a naked sale. If you trade put and call spreads, you probably don’t want to distort your strategy just to get a ‘discount’ in the form of a lower IV. Those discounts are not large – and it is okay to take advantage of skew when trading one put (or call) is as reasonable as trading another. But don’t force a trade just to get a small extra edge.

      Understand it better. That’s good. Forcing trades to take advantage – it’s far to soon to do that. There are many other factors to consider when choosing the specific option to trade.

      Regards