hedging a portfolio against a black swan

[srinir]

I don't think you stress tested for black swan event. 12 month long term put IV does not explode during the time of stress, what explodes is IV of your short term put sale.
Most of the traders are levered, when the risk limit is hit they have two choices cut risk and buy insurance. Your sale of short term puts to finance not only does not cut risk in that event, but adds to the risk.

 

[Kim Klaiman]

I don't think you stress tested for black swan event. 12 month long term put IV does not explode during the time of stress, what explodes is IV of your short term put sale.
Most of the traders are levered, when the risk limit is hit they have two choices cut risk and buy insurance. Your sale of short term puts to finance not only does not cut risk in that event, but adds to the risk.

Of course we did a stress test.

Both IV explode. But the delta of short term puts becomes almost 1 once they become deep ITM with very little time value left. But long term options will still have a lot of time value.

You continue ignoring the fact that we sell much less puts than the number of the long puts. The number of net long puts (long minus short) is just enough to fully hedge the portfolio.

 

[newwurldmn]

Of course we did a stress test.

Both IV explode. But the delta of short term puts becomes almost 1 once they become deep ITM with very little time value left. But long term options will still have a lot of time value.

You continue ignoring the fact that we sell much less puts than the number of the long puts. The number of net long puts (long minus short) is just enough to fully hedge the portfolio.

Your long dated put will have less than 1 delta. So you will effectively be long delta from your hedge, making the next gap down more painful.

Further the curve moves in root time so the back doesn't rally as much as the front in times of stress. While you are long rt vega it's unlikely to be fully hedged to the core long unless you are running like 10x in the puts vs the core long.

 

[Kim Klaiman]

Your long dated put will have less than 1 delta. So you will effectively be long delta from your hedge, making the next gap down more painful.

Further the curve moves in root time so the back doesn't rally as much as the front in times of stress. While you are long rt vega it's unlikely to be fully hedged to the core long unless you are running like 10x in the puts vs the core long.

Maybe an example will help.
Lets say you want to fully protect a 100k portfolio. SPY at 245.

Scenario #1:
You buy 4 long term (say Sep2019) 245 puts around $15 each. Your cost is around 6k or 6% of the portfolio. If SPY stays above 245 or goes up, your hedge cost is 6k (all gone). If it crashes say 50%, you are fully protected - less the cost of the hedge if it happens close to expiration. If it happens long before expiration, there still will be some time value left, so your protection will be better.

Scenario #2 (the Anchor):
You buy 8 long term (say Sep2019) 245 puts and sell 4 short term 245 puts every week or so. If SPY remains around the current levels, you are likely to recover most if not all the cost of the long puts. If SPY crashes, the gain in 4 long puts will more than offset the loss in 4 short puts, but the remaining 4 long puts will provide the same protection as scenario #1. So the protection is actually better in scenario #2.

The worst case scenario for the Anchor is market going up 3-5% then down 3-5% few times. In this case we will be whipsawed and not likely to pay for the hedge.

 

[newwurldmn]

Maybe an example will help.
Lets say you want to fully protect a 100k portfolio. SPY at 245.

Scenario #1:
You buy 4 long term (say Sep2019) 245 puts around $15 each. Your cost is around 6k or 6% of the portfolio. If SPY stays above 245 or goes up, your hedge cost is 6k (all gone). If it crashes say 50%, you are fully protected - less the cost of the hedge if it happens close to expiration. If it happens long before expiration, there still will be some time value left, so your protection will be better.

Scenario #2 (the Anchor):
You buy 8 long term (say Sep2019) 245 puts and sell 4 short term 245 puts every week or so. If SPY remains around the current levels, you are likely to recover most if not all the cost of the long puts. If SPY crashes, the gain in 4 long puts will more than offset the loss in 4 short puts, but the remaining 4 long puts will provide the same protection as scenario #1. So the protection is actually better in scenario #2.

The worst case scenario for the Anchor is market going up 3-5% then down 3-5% few times. In this case we will be whipsawed and not likely to pay for the hedge.

Okay. This makes sense. You have two trades: a synthetic long call and a calendar spread. The synthetic long call is obvious what the risk and reward is. The calendar spread is a little trickier. The spread is a short gamma position and thus will lose on a large move in either direction - granted the max pain is fixed it's not insubstantial at (7percent of the account). Any subsequent hedging you do on may or may not reduce the pnl on the spread.

So the bad cases are: the market rips and you lose on all the puts and can't really sell anything to hedge (because your long outs are so otm).

The market sits here and you underperform because you will never generate enough premium from the calendar to pay for all the puts you are long.

But because you aren't really leveraged, the strategy is pretty safe. I have to think about it more. There's some degree of anti-correlation between the two positions and that's pretty good.

 

[Kim Klaiman]

Obviously no strategy will work 100% under all market conditions. You might need to reoposition the long puts on a sharp move up, and you might be whipsawed if it reverses sharply.

But the point is that as a hedge, it is very effective, and protects you against major losses. Are you willing to give up 2-3% per year for the piece of mind you get? This is basically similar to putting some of the portfolio into bonds - you reduce your gains, but also reduce the risk. But stocks/bonds portfolio will also have significant losses if the market is down 50% (unless you put 80%+ in bonds), while Anchor is fully protected.

 

[Crr000]

https://www.linkedin.com/pulse/worried-stock-market-crash-heres-how-you-can-tail-hedge-jesse-felder

I am considering employing a strategy similar to that described in the link above. Being relatively inexperienced to option trading, I have obvious concerns about not fully understanding the implications of such a strategy. I realize that many will think to offer me advice to steer clear. Thank you for the advice and I may end up heeding it. But I need more information before I can decide what works best for me.

I understand that the majority of the time I would roll options and 'lose' money. That seems like the easy part. Most of my questions center on what happens if there is a large down move and suddenly the puts are ITM:

-- Would there be any risk in a crisis that I would be unable to sell the now ITM-puts before expiration? I am trying to understand (1) what the probability is of not being able to sell the puts and (2) what would be the process if they expired in the money--would I need to come up with 5000 shares of SPY to sell at a profit? What if I don't have enough capital to purchase?

-- Let's say I bought contracts for October expiration on Sept 1, and around Sept 15, there was a large down move (30-40%) and those puts were now ATM or ITM. Would a smart investor sell those at this time (and purchase November expirations) or hold to the end of the month and roll them into a Novembercontract? Would the prices of November OTM puts likely increase significantly in the setting of such an event? Will liquidity be negatively affected in the setting of such an event?

Thanks in advance to any replies or advice.

 

[Kim Klaiman]

There is one serious issue with this strategy: it aims to protect against 20% decline in the span of just a month. And it might achieve this goal if 20% indeed happens in one month.

The problem is that this is usually not the case. In fact, I don't think it ever happened. Even in 2008, the decline was much more gradual. If SPY declines by 5-7% a month, 30% OTM puts will NOT provide adequate protection. They might increase by few hundred or even thousand dollars, but when it's time to roll, the next month puts will also be much more expensive.

To demonstrate this, I backtested the strategy for 2008 when SPY was down almost 40%. I bought $500 worth of 30% OTM puts and rolled them each month, pretending to protect $100k portfolio.

Here are the results:

As you can see, the trade was losing money most of the year even during SPY gradual declines, and only in August-October it made some money during the most severe declines. But the total yearly gain was just over $3k, or 3% for $100k portfolio. Also remember that the backtesting used mid prices which in reality is not realistic, and excluded commissions. If you add slippage and commissions, the total P/L would be close to zero.

And during sideways or up years, 80-90% of the premium spent will be gone. When you include commissions, you would be spending 0.5% per month or 6% per year for protection, which is too much anyway.

The bottom line: this strategy spend 6% per year for protection, and when protection is needed, it will not provide it in most realistic scenarios.

 

[ironchef]

https://www.linkedin.com/pulse/worried-stock-market-crash-heres-how-you-can-tail-hedge-jesse-felder

I am considering employing a strategy similar to that described in the link above. Being relatively inexperienced to option trading, I have obvious concerns about not fully understanding the implications of such a strategy. I realize that many will think to offer me advice to steer clear. Thank you for the advice and I may end up heeding it. But I need more information before I can decide what works best for me.

I understand that the majority of the time I would roll options and 'lose' money. That seems like the easy part. Most of my questions center on what happens if there is a large down move and suddenly the puts are ITM:

-- Would there be any risk in a crisis that I would be unable to sell the now ITM-puts before expiration? I am trying to understand (1) what the probability is of not being able to sell the puts and (2) what would be the process if they expired in the money--would I need to come up with 5000 shares of SPY to sell at a profit? What if I don't have enough capital to purchase?

-- Let's say I bought contracts for October expiration on Sept 1, and around Sept 15, there was a large down move (30-40%) and those puts were now ATM or ITM. Would a smart investor sell those at this time (and purchase November expirations) or hold to the end of the month and roll them into a Novembercontract? Would the prices of November OTM puts likely increase significantly in the setting of such an event? Will liquidity be negatively affected in the setting of such an event?

Thanks in advance to any replies or advice.

Welcome to ET and thank you for the link.

What I learned after 4 years of trading options is there is no free lunch and any simple mechanical way to trade options will usually net you a negative return after slippage and commissions. So, the simple put buying described in your article will cost you as Kim described in his post. Hedging with 30% OTM puts will protect you from a black swan but likely will reduce your underlying's overall returns.

To get a positive return, as a mom and pop small retail trader, I have to have a "correct judgement" of the outcome, i.e., buy puts only when I believe the underlying is "overbought" rather than consistently buying every month.... I assume professionals with their high power tools can extract positive returns with an auto algorithm but not I.

I welcome further comments from you and others.

 

[beerntrading]

https://www.linkedin.com/pulse/worried-stock-market-crash-heres-how-you-can-tail-hedge-jesse-felder

I am considering employing a strategy similar to that described in the link above. Being relatively inexperienced to option trading, I have obvious concerns about not fully understanding the implications of such a strategy. I realize that many will think to offer me advice to steer clear. Thank you for the advice and I may end up heeding it. But I need more information before I can decide what works best for me.

I understand that the majority of the time I would roll options and 'lose' money. That seems like the easy part. Most of my questions center on what happens if there is a large down move and suddenly the puts are ITM:

-- Would there be any risk in a crisis that I would be unable to sell the now ITM-puts before expiration? I am trying to understand (1) what the probability is of not being able to sell the puts and (2) what would be the process if they expired in the money--would I need to come up with 5000 shares of SPY to sell at a profit? What if I don't have enough capital to purchase?

-- Let's say I bought contracts for October expiration on Sept 1, and around Sept 15, there was a large down move (30-40%) and those puts were now ATM or ITM. Would a smart investor sell those at this time (and purchase November expirations) or hold to the end of the month and roll them into a Novembercontract? Would the prices of November OTM puts likely increase significantly in the setting of such an event? Will liquidity be negatively affected in the setting of such an event?

Thanks in advance to any replies or advice.

The point of that strategy isn't to go ITM, you just set your limit order and lift it when roll.

But the point made by Kim is vital about the crash happening too slowly. Or, even if it happens quickly but starts at the wrong point in your cycle. Once the VIX event starts, you're pretty much locked into your position because the OTM puts are too expensive to justify the roll while the soon to expire ones are too far otm to get a big hit by the vol. The obvious answer to this is longer time frames, but then of course your 30% otm purchased in January is 45% otm in October...

As ironchef says, there's no free lunch.