I follow your blog, having read your "hedge fund" book about a year ago
… which was my introduction to options. A very understandable book,
BTW. Since then I've used covered calls pretty well … making a few of the classic mistakes along the way.
Just read your entry about "beating the market". I am looking at
doing a "hedged put-writing strategy", which I've read about in another
book (Put Options by Jeffrey Cohen).
The idea is that you write
puts on individual stocks, then hedge by buying OTM puts on one or more
of the indexes. I don't think I've seen you mention that strategy. Is
that an approach that you approve of?
The idea is that you sell the puts on the individual stocks — stocks
that you've done some research on. He has some guidelines for picking
those. He recommends selling longer term options to generate a decent
And then buying the index puts as the hedge, because the implied volatility is lower on the index, your "insurance" is cheaper.
all (or a large proportion) of your stock picks happened to decline
more than the index, you'd lose. That seems to be one of the drawbacks.
I don't like that specific approach. In fact, I'd prefer to do just the opposite of what you are suggesting.
In practice, indexes are less volatile
than individual stocks (some stocks move up, others down, negating part
of the volatility). Thus, selling naked options or spreads on an index is less likely to
result in a loss than selling options on individual stocks. In return for that reduced volatility, you collect a lower option premium.
By buying puts or calls on individual stocks, you are hoping for a major news
announcement and thus a big change in the price of the stock. I've never tried
this, but it's a strategy that has supporters. Cohen is suggesting you do just the opposite. This is a personal situation for me, and many investors/traders disagree: I do not like to try to pick stocks that will out- or under-perform the market. By doing 'some research' your strategy requires just that. Thus, it's not for me. But is it for you? that's your decision.
Is the purpose of this strategy to sell puts in stocks you are willing to own? Is it based on the premise that you have the ability to pick winning stocks? To balance the risk of
market movement in the wrong direction (down in your scenario), or of exploding implied
volatility on puts you sold, the idea is to buy index options to hedge those risks.The idea is to prosper by having your stocks outperform the market.I
If that's the rationale behind this strategy – and I don't know what Cohen is thinking here – I don't like it. First I believe the vast majority of traders are unable to outperform the market. Yes, day traders play for short-term swings, and many appear to make good money, but investors have longer holding periods. If you know you can pick winners, from a proven track record, then this method is appealing. But it's not for the majority.
Second, the margin requirement for these positions is much higher than when you hedge your trade with options on the same underlying.
Third, I don't like the correlation risk. Sure, you sell puts in stocks you like, but as I mentioned, they are not going higher just because you like them (for most traders).
This method works when your stocks don't collapse. It doesn't cost when nothing moves and all options expire worthless.
There is one problem if you choose volatile stocks – you may pay too much for your long options. Obviously this can be balanced by selling the same dollars worth of index options as you pay for your options – but be certain to use a risk graph so you do not oversell index options and incur a loss on a big move.
This is a trading idea for which some practice is required. You must learn how to determine how far OTM the index options should be and how many to sell. This sounds right for a short research study – paper trading.
Getting back to the correlation risk mentioned earlier. I know it's much safer to hedge the specific puts you sell, rather than taking the generic stance of buying index options. If you sell a bunch of AAPL 180 puts, wouldn't you feel more comfortable owning APPL 175 puts than some NDX puts? I would.