hedging stock with index options

Baozi

Baozi

Hello everyone..

so, let's assume that I already did my analysis and I decided to buy stock A. My system however has the classic distribution of a breakout system, with a few big winners and many small losers. There is therefore a good chance that stock A will go down. I would like to hedge my bet.

Main problem: In my market I cannot short stock and I can only buy/sell options on an index ETF (stock A is part of the index).

I am going to:
1-determine how many stock shares to buy (according to my position sizing rules)
2-determine the correlation coefficient between stock and index over the past few months
3-Buy enough negative delta so that they are equal to (shares to buy / correlation coeff.)

Is this reasoning sound? Any advice? Should I aim to have a full hedge or just a partial one? Anyone doing something similar that would care to share his/her experience?
 
It's a very difficult position to hedge unless your stock holds a significant weight of the ETF and past correlation holds. You are basically laying out a situation where hedging simply may be ineffective. We trade a similar position in our shop and we've tested various hedging instrument with little success - plus the position is very concentrated. Our solution was to try to hedge their largest customers. Is there an ETF that might have a better correlation to their core business cash streams. Our issue is an illiquid bank which lends in the energy space. Since we can't effectively hedge the bank - we hedge the energy space. Depending on your resources - some of the data vendors have correlation models on their platforms. The challenge here is that many instruments that are difficult to hedge correlate well to other instruments that are equally hard to hedge.
In the U.S. one of the ways to hedge housing starts and growth was through lumber derivatives. Today more of the builders are public and there is some liquidity. Haven't looked at that one for years, but try to think out of the box and examine what instruments are available to you.
 
thats my point. I dont have much choice in my market.

The index ETF however does not represent a big basket, its just 50 big cap stocks. Correlations on most components are fairly stable, on average around 70%, I would not consider lower coefficients. Could this be a mitigating factor?

ETJ, what would be the timing of your strategies? Are we talking of days, weeks or months?
 
What is your risk profile?
Determine what you can or can't afford to lose and work from that.

Many times the best way to execute is just to take smaller position or set stop loss.
 
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Alexpung said:
What is your risk profile?
Determine what you can or can't afford to lose and work from that.

Many times the best way to execute is just to take smaller position or set stop loss.
More...

thats exactly what I have been doing so far. However I would like to try using options instead of a hard stop, mostly to avoid the frequent whipsawing associated with a breakout system.
 
Baozi said:
Hello everyone..

so, let's assume that I already did my analysis and I decided to buy stock A. My system however has the classic distribution of a breakout system, with a few big winners and many small losers. There is therefore a good chance that stock A will go down. I would like to hedge my bet.

Main problem: In my market I cannot short stock and I can only buy/sell options on an index ETF (stock A is part of the index).

I am going to:
1-determine how many stock shares to buy (according to my position sizing rules)
2-determine the correlation coefficient between stock and index over the past few months
3-Buy enough negative delta so that they are equal to (shares to buy / correlation coeff.)

Is this reasoning sound? Any advice? Should I aim to have a full hedge or just a partial one? Anyone doing something similar that would care to share his/her experience?
More...
@sle mentioned a book by Colin Bennett on Volatility Trading. I read it and in it he talked about correlation trade. If your underlying has a good correlation with an ETF, it is a legitimate hedge of your underlying. You do have to get your delta neutral correct to be a real hedge. Besides, like @dozu888 said, for us amateur retail, hedging is difficult because of commission and slippage since for a hedge to work, you have to dynamically hedge. And I think if your hedge is perfect, your profit will = risk free rate?
 
I can't offer much on this, but I would like to post my thoughts on this and see what people think.
Let's say I'm long the stock (AAPL), I will sometimes open short position in ETF(QQQ). The idea is that while it's not well correlated in normal conditions, it will become very correlated in case of sharp sell off. So I get the benefit when it really matters. I am not worried about small moves against me, but rather a sharp sudden move. Does this make any sense? Not very scientific, I know.
 
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