Hedging

[ironchef]

Hi all,

Would this kind of method work?:

Portfolio with

100 000 $ long in stocks

100 000 $ short in options (equivalent of 100 000$) if the market crashes (as an insurance)

Will this work or is it not worth the effort because of the large cost of insurance you pay in case something bad happens?

Are there less costly ways to hedge your portfolio?

TIA

If you cannot take the risks of market going up and down, you should not invest. And as Jones75 said, for a long term investor, to buy put to protect your gain is counter productive, you will end up with no gain since you will have to buy them continuously to cover all occasions. If you don't buy continuously, you are liable to guess wrong.

As an example, let's look at AAPL, a 1 year ATM put costs about $11.5 per share, that is 10% of the current stock price. AAPL stocks + dividends have to go up 10% a year for you to just breakeven. Shorter term puts are even more expensive and even more so at time of market turmoil like 2008 when you really need it.

Did I just argue that short AAPL puts are good investments?

That's silly -- it's like saying "When your house doesn't burn down, are you going to be happy about the cost you paid for insurance?"

I beg to disagree. As an investor we should accept some fluctuations of the market but for a house, you cannot afford to have it burned down especially if you have a mortgage.

 

[haroldg]

Some people can afford to self-insure their homes. But most people can't.

 

[Sig]

That's silly -- it's like saying "When your house doesn't burn down, are you going to be happy about the cost you paid for insurance?"

If insurance cost 10% of my house's value each year it wouldn't be silly at all. Making apples to oranges comparisons may be called silly by some.

 

[Trader13]

Hedging can be done across a range of risk, so you have to be specific about how much risk you're attempting to offset with the hedge. If you are buying ATM or ITM puts, then you are hedging away virtually all of the downside risk, but at the very high cost of the hedge which makes this a poor approach (there are some exceptional cases where it might make sense, e.g., deferring a tax sale).

I've found that options used as a hedge are a better value when used for tail risk only. IOW, buying a DOTM option to hedge against large adverse moves. Then apply other risk techniques to address the more common adverse moves (e.g., diversification, spreads).

 

[stockoptionstrader]

Yes It's what I thought, that insurance in case of... is costly.

 

[haroldg]

Long stock + long ATM put == long ATM call (setting aside second-order details), if you'd prefer to think of it that way. You're effectively buying a one year AAPL ATM call for$11.50. Whether that's a good or bad deal is unclear, but a screaming bull will get more bang for the buck owning 9 ATM calls for ~$100 total, versus 1 share for ~$100.