Hedging w/Backspreads vs. Protective Puts

J

jones247

A fundamental problem with using puts for a static delta neutral hedging is the cost... This is an extremely expensive way to protect your profits over several months. That's why many would enter a collar, to help offset the cost of the put. However, it's perplexing to me as to why not many folks consider replacing the put or the collar with a near month backspread.

Imagine being long an ultra long etf or other volatile asset. Believing that it's due to breakout, but worried about a collapse of the instrument. The most cost effective method (especially if the instrument is volatile) of protecting your downside and having the confidence of staying with the trade is to enter a backspread.

How many times have people stated that they really want to stay in a given position, but had to liquidate because the near term price action was contrary to their position. However, shortly after exiting their position, they watch the market eventually take off as they knew it would.

Of course, the backspread works equally as well when protecting a short position.

Walt
 
I not sure if I understand your statement... are you saying that many folks who are long don't care to hedge against a drop in the price of their position. In other words, if I long IBM, then I don't care or worry about the price of IBM falling, especially in a material way?
 
Yep, a backspread is a lower cost way to hedge long stock but it's going to have a much larger risk loss potential to the downside, perhaps as much as 3 strikes because you have 100 delta loss on the falling underlying plus higher delta loss on the strike sold versus that of puts bot.

Since you're protecting stock, you're going to have to have at least a 3:1 ratio (which will most likely be a debit) otherwise your risk graph will have a similar shape as put protected stock.

To keep more of the upside potential, IMO, a wider collar would be better (sell next higher call strike) and generally, it won't cost a heckuva a lot more than the backspread.
 
Spindr0... you actually gave me an idea worth pursuing...

Perhaps it would be best to combine a backspread with a collar. In other words, if I have a long position. I would enter a put backspread and a wide short call to help offset the potential risk associated with the backspread.

Any thoughts...

Walt
 
Quote from jones247:

Imagine being long an ultra long etf or other volatile asset. .. The most cost effective method (especially if the instrument is volatile) of protecting your downside and having the confidence of staying with the trade is to enter a backspread

Walt
More...


Hi Walt,

1) It is a very bad idea to own any ultra-hedged ETF. You would be FAR better off to own 2x or 3x as many shares of the 'regular' ETF. If you don't know why I'm saying this, you can research why ultra hedged ETFs have a built in tendency to lose value over time. And this has a significant effect on P/L.

2) The backspread may be cost effective if the market runs higher - as you hope it will. But the purpose behind owning protection is to actually be protected. The backspread is only disaster insurance.

3) The problem with the back spread is that a decline may not be large enough to bring your long options into play.

You would then lose on your long position; lose on your short put position; and lose on your long put position, as your longs expire worthless.

The backspread has enough risk (yes, with large potential rewards) in it's own right. I don't believe it is wise to attach it to a long position. Too much downside risk, when the stock price does not collapse.

The collar does a far better job. If you want the upside play with protection, I don't believe the put backspread is the way to go.

Mark
 
Adding short OTM calls to your backspread would mildly offset some of the risk of the backspread. But to repeat, I think the put backspread idea does a poor joib of protecting long stock.
 
Thanks for the reminder about ultra etf, as I do recall reading some time ago that they tend to lose value over time, with all things being equal.

Spindr0 & Mark,

I appreciate your recommendation on a collar over the backspread as downside protection. I guess the only way that I would consider a collar is to short the stock, sell a put & buy a call, since the premiums are better with a put.

Given the adverse aspects of a backspread, perhaps a put ratio spread would be better... or maybe a put butterfly would be best as a downside protection against a long position.

I'm really trying to find a way that ultimately provides downside protection without the high cost, while allowing a big upside potential.

Walt
 
Quote from jones247:

I'm really trying to find a way that ultimately provides downside protection without the high cost, while allowing a big upside potential.

Walt
More...

Me too! :)
 
Maybe my time would be better spent trying to find Big Foot riding a Unicorn, as opposed to finding a low/no cost & low/no risk downside protection mechanism...

Walt
 
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