Picking the Right Hedge

Mark,

I think
what I might not fully understand on Risk Management is exactly what
type of hedge is needed. For example: On my Cash secured puts..what is a
good hedge, is it buying long puts and when? When the market starts in
the other direction or when first selling the puts?  What type of hedge with
what type of trade?

Donald

***

You enter into a trade with the expectation of being able to earn a profit.  If all goes well, you exit the trade and collect the profit.

When the trade is not working, you have choices.  The first is to stubbornly hold that trade.  In my opinion this is foolish, unless you (be honest with yourself) truly want to own the trade with its current risk and reward potential.

The next obvious choice is to acknowledge that this specific position is not working and that you no longer have any confidence that it will work. Exit the trade.  There is no reason to hedge or adjust a position that no longer meets your needs.

The most popular choice among option traders is to hedge (reduce the risk of holding) the trade.  Your question deals with knowing what to do when making this adjustment to your position.  Before replying, I must mention that attempting to salvage a bad position – with the hope of recovering losses – is an over-utilized strategy.  

The only time (this is my opinion, not a law) to adjust a position is when you can modify it so that it meets your qualifications for a new trade.  In other words, ignoring any loss incurred so far, the position – after it is adjusted – must be 'good,' i.e., you want to own it.  Remember it's quick and easy to exit, so if you make the adjustment it should be because you like the prospects of the altered position.

Far too many traders 'fix' the current problem, hoping to recover losses – and not because the fixed position is worth holding.  This is a trap.  Do not fall into it.  You already incurred the loss, so your job as an intelligent trader, is to find the best way to invest your money going forward.

Let's assume you elect to hedge the position.


There is no 'best' answer to the dilemma: Which hedge to choose?

Your position is naked short puts.

1) Size the trade. The maximum possible loss must be acceptable – not be a happy event, but one you accept.  Thus, the first hedge occurs at the time of the trade: don't sell too many puts.

2) Yes, buying other puts is the easiest and safest method for reducing risk. It's my first choice, but that does not mean it's your first choice.  It costs cash to buy puts and not every trader is willing to make that trade.  It severely cuts profit potential, but it also establishes a maximum loss.

But does it give you the position you want to own?  There was a reason you chose to sell naked puts, rather than put spreads.  That suggests that this is not the right hedge for you.  If it is, you must understand why you prefer to sell naked puts as the initial trade.

3) If you elect to buy puts for protection, when is a good time?  There are many reasonable times. 

You can buy when you enter the trade.  That means selling a put spread instead of just selling puts.  That's a different risk/reward profile – and no one can tell you which trade is better suited for you, your investment style, your investment goals, and your tolerance for risk. That is for you to decide.  No one can help with this decision.  If your goal is to aggressively seek profits, then put spreads may be too conservative.  If your goal is profit with reasonable risk, then put spreads should be more appealing.

You can hedge when the market rallies and the put becomes cheaper, but most people avoid that, believing the hedge is no longer necessary.

You can buy puts on a decline, when the position becomes more risky to hold. It's more expensive to buy puts in this situation, but to compensate, there will be many instances in which you never have to hedge.

There is no correct answer.  There is no best way to handle this decision.  There is only your trade plan.  How much risk are you willing to take?  How much reward do you need to take that risk?  When do you acknowledge that the original plan is not working?

4) What type of hedge with what type of trade?  This is a topic that I'll be covering to some degree in the series on risk management, but you must know there is no universally accepted correct answer.

Donald, I think you are looking for simple answers to complex questions.  They do not exist.  For example, some traders prefer to hedge a short put (your trade) by selling a naked call.  I would never do that (although I did it many times, many years ago).  It's too risky for me.  But how can I know if it's too risky for you?

If you decide to buy puts, how will you choose the strike price or the expiration date, or the quantity to buy?  There are many ways to attack this problem.  My suggestion is to consider several alternatives, examine the risk graph for each and find a scenario that leaves you with acceptable risk and sufficient reward.

This may seem to be a big time waster, but it's not.  Eventually you will find a style of put buying that works for you.  There are so many reasonable choices that you must (ok, should)  practice (paper trading account?) to see which type of trade leaves you in a comfortable position. 

Some traders prefer to do nothing until the trade reaches a point where prudent risk management dictates exiting and taking the loss.

Some traders use shares of the underlying stock to occasionally move the trade back to delta neutral.  This is a very popular method.  I don't use it, but that doesn't mean you shouldn't.

You have to find your own answers.  I hope this reply has given you enough to begin the search.

689


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The Case for Commodity Options. Jared Woodard discusses commodity volatility and why its profile is so different from that of equities.

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4 Responses to Picking the Right Hedge

  1. Joe 05/13/2010 at 8:38 PM #

    Hi Mark,
    Iv’e trying to work out a way of planning out a method of determing when to initiate what type of protection for my IC positions under different conditions. I know this is quite the task and will vary from one trader to the next. I have decided to focus on using kites and would like to know what you think of this method:
    Lets say I have decided an adjustment is needed as one of my short strikes is under threat. So, if the market is moving fast in a high IV environment a K4 would be used. If the market is moving not as fast a K3 could be used and if it’s quite slow than a K2. Do you use any type of guide like this?

  2. Mark Wolfinger 05/13/2010 at 8:50 PM #

    Hi Joe,
    Good question. I’ve never done anything like you suggest. If you exit well before expiration, it sounds very reasonable. If you hold longer, something else takes precedence.
    Why? The biggest risk when owning kites is that you may hold them to expiration. That’s when they become much riskier. That final day or two can be a killer (or very rewarding). Take a careful look at the risk graphs to see that this is true.
    Thus, when choosing the spread portion of the kite, I want to be careful not to add to the already substantial expiration risk – and that’s negative gamma. I know I want to exit early and thus, any kite should be okay. The truth is I don’t always exit early, so the shape of the risk graph, and where I could get into trouble, becomes important. That makes strike selection crucial. I’ll trade the K3 or K4, depending on which makes for a better looking risk graph. That’s just another subtlety with which to deal.
    When I feel threatened, I’ve begun using K(4-1). That refers to the options used in a K4, but selling only 3 spreads per long call. Costs more and adds better protection.
    I don’t use a K2. For me, that’s a butterfly plus an extra wing option. I don’t need the butterfly (although other traders may want to own it), so would prefer just to buy that wing option (raising another objection: that wing option is usually too FOTM for me to buy as protection).

  3. Joe 05/13/2010 at 11:47 PM #

    Mark,
    Thanks for the quick response. I tend to put on kites when my own personal adjustments points have been hit and then look to take them off well before 3 weeks to expiration. There are many things to consider when using kites and I’m still working on how to best determine the criteria for choosing which kites would be deemed suitable for which conditions. So it’s just an idea at this stage that has’nt been put into practice but I think it’s the kind of thinking that could assist rookies in making decisions come adjustment time.

  4. Mark Wolfinger 05/14/2010 at 7:18 AM #

    Joe,
    I agree that there is still much to be solved in the ‘when to use kites and which is the best for a given situation’ realm.
    The ideal situation is to open a paper trading account and manage a doze such positions simultaneously. I’d collect data quickly. Alas, that’s a full time job in itself.
    I think this type of adjustment has much to offer, but I just don’t have all the details worked out. If you make any discoveries as you gather data, I’d appreciate your sharing some conclusions.
    Best regards