hedging stock with index options

[Baozi]

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.

This makes a lot of sense.

 

[Baozi]

@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?

The base assumption for me taking the trade is that the stock will outperform the index. Assuming I am long puts, my expectation is that eventually the stock gains will outsize the put losses. I agree with you that having a perfect hedge is useless, but consider that the deltas of the options are dynamic while the deltas of the stock are almost static (depending on the correlation). You could have a situation where you start with a partial hedge that becomes full as the stock tanks.

 

[ETJ]

You don't need a perfect correlation in most cases. In fact, often, the more perfect the hedge - for many instruments or baskets - the more expensive. If I can hedge out 80% of a big move against me - that may be the best I can actually achieve.

 

[ironchef]

The base assumption for me taking the trade is that the stock will outperform the index. Assuming I am long puts, my expectation is that eventually the stock gains will outsize the put losses. I agree with you that having a perfect hedge is useless, but consider that the deltas of the options are dynamic while the deltas of the stock are almost static (depending on the correlation). You could have a situation where you start with a partial hedge that becomes full as the stock tanks.

Good comments.

Yes, anytime you trade a pair or combinations, there is usually a hedge somewhere: a spread is a hedge.

 

[Baozi]

My big unanswered question here, (cit. Destriero) is not about edge but about structure. What is the best way to hedge this trade? long puts or short calls? Buy a few ATM or buy a lot OTM? If starting with a partial hedge how much % to cover? I was hoping that some of the big options guys on ET would chime in to give some insight.