Hedging big overnight moves?

heech · Mar 2, 2009

Hi,

I'm trading a strategy that leaves me pretty exposed on delta to the downside... not a problem during the day, but large overnight moves (say +/-4%) have the potential of really hurting me. And I don't get any of the upside.

My question is... what's a good choice for hedging against major overnight moves? I'm thinking options or other derivitives for the leverage, obviously. I was contemplating opening the position at 3:55 PM every day, and then closing at 9:45 the following morning.

I figure I'll lose a little due to theta, but not much. The obvious choice would just be a straddle...

But I'm just a boring uninformed retail guy, so I don't know about a lot of the possibilities out there. Any other strategies that would make sense? Any suggestions on what symbol I should straddle on? Just SPY?

drcha · Mar 2, 2009

Would you feel comfortable posting a bit more information about the type of trades you are doing? It would be easier for others to help you if we knew the type of position you carry.

heech · Mar 2, 2009

Quote from drcha:

Would you feel comfortable posting a bit more information about the type of trades you are doing? It would be easier for others to help you if we knew the type of position you carry.

Sure...

I'm only holding both covered and naked calls, usually in very volatile stocks.

If market moves significantly to the downside overnight, then the covered calls get hit hard. If the market moves significantly to the upside overnight, then the naked calls get hit hard.

I don't want to change the nature of my underlying strategy... and I don't expect to really delta hedge individual stocks. I'm pretty diversified, so I'm okay with individual stocks getting hit...

... I just don't want to be caught long after a 9/11-type attack, if you know what I mean. I'm just trying to hedge big movements in the broad market as a whole.

Carl K · Mar 2, 2009

It sounds like a Straddle or a Strangle would be the simplest, depending on if they are at different strikes or not.

spindr0 · Mar 2, 2009

On an individual basis, you can hedge covered calls overnight by buying the same strike put, resulting in a conversion. No matter what happens in the AM, you won't be hit. However, it's not a very efficient strategy since it racka up a lot of slippage and commissions. You'd need a big edge to overcome that.

Similarly, you can convert your naked calls to spreads but again, also not very efficient.

Chances are, your best bet would be an OTM stangle on an index that typifies your holdings. How far OTM would depend on your comfort zone with the balance b/t protection and cost. The strangle would put a market floor under and above the current levels.

heech · Mar 2, 2009

Great feedback.

Any specific reason why you'd recommend a strangle versus straddle in this case? I know straddles "cost more" if held to expiration...

... but I'm dumping first thing in the morning, so the fact that I'm paying a premium for ITM options shouldn't be too much of an issue... right?

I'll look for an index with a narrow spread, that approximates my portfolio.

spindr0 · Mar 2, 2009

Quote from heech:

Any specific reason why you'd recommend a strangle versus straddle in this case? I know straddles "cost more" if held to expiration...

I have no clue what you're specific positions are (I'm not asking) but I'm assuming that since you're doing it, it's working for you. Given that you initially asked about catastrophe insurance, such as 9/11 meltdown protection, I suggested a strangle since the further OTM, the lower the cost. The closer you get to the money, the greater the cost and the more drag it will put on your initial positions should things trade in a box. Hedging is a trade off b/t protection and cost.

You'd have to model possible results to determine if a straddle was more suitable to your circumstances than a strangle.

heech · Mar 3, 2009

Hmm, what's the right way of thinking about this? "Delta per dollar cost"?

And I guess I just want to maximize delta per dollar cost, get the most bang for the buck... and ignore all of the other greeks? I'll look at the numbers and see what makes sense.

Thanks again.

spindr0 · Mar 3, 2009

Quote from heech:

Hmm, what's the right way of thinking about this? "Delta per dollar cost"? And I guess I just want to maximize delta per dollar cost, get the most bang for the buck... and ignore all of the other greeks?

OK, a recap (g). In your earlier posts, you indicated that:

1) You're holding both covered and naked calls, usually in very volatile stocks.

2) If market moves significantly in either direction overnight, one side or the other gets hit

3) You don't want to change your strategy, you don't want to hedge individual stocks and you're pretty diversified.

4) You indicated the possibility of opening a hedge position at 3:55 PM every day, and then closing at 9:45 the following morning

So that means that you need an index to hedge globally rather than individually. And if it's a strangle on a market index, you won't have to open and close it daily. It will be in place, protecting you until expiration and you won't incur all the slippage from daily hedge trading. If the market moves a fair amount, you may have to add more puts or calls to the side that gets further OTM in order to maintain suffiecient protection but that's just fine tuning.

Here's my overall take. Given a fair amount of leeway in interpretation, since your positions are diversified and involve covered calls as well as naked calls in different stocks, essentially, you're selling strangles. OK, maybe pseudo strangles. If you have enough posiitons, you become a small index of sorts.

By buying an OTM strangle on a similar index to your components, you're creating a pseudo Iron Condor. And that young Watson is where you should look for strategy guidance, eg. "getting the most bang for the buck".

jwcapital · Mar 3, 2009

When I used to trade covered calls on the ES (s&p 500 eminis), I would cover my downside by buying OTM puts. Then, come the morning (usually after 9:30AM when the Futures options are more liquid), I would close out the puts either at a profit or break-even. You can repeat this nightly and cover yourself over the weekends. I believe that if you try to use ATM puts that your "insurance" may be too costly--I never really analyzed this possibility. Perhaps others here can comment.