Before going into the FAS hedging question, that you at this point have already guessed from the screenshots is based on options, let me make a quick introduction to the concept of protecting with options within the algorithmic system. We have already seen, in the previous post, how to deal with expired option to fully <b>integrate them within the algorithm</b>, I have to explain however a bit how we use and choose the options in the first place.
<b>WHAT IS AN "OPTION PROTECTION UNIT" ?</b>
In its simplest form a "protection unit" (a made up term) is formed by a pair of options with same expiry which are sold and bought simultaneously in possibly different quantities, N and M, in such a way that the options being sold are able to "repay" the time decay of the options which are being bought. So, as anticipated in a previous post, we can have:
<i>Protection against price increase</i>:
1) +N CALL1s/ -M CALL2s
2) +N CALLs / -M PUTs
<i>Protection against price decrease</i>:
3) -M PUT1s / +N PUT2s
4) -M CALLs / +N PUTs
The conditions ("time decay repay") obviously are respectively:
1) (M * CALL2 Bidprice - N * CALL1 Askprice) * Multiplier > UserThreshold
2) (M * PUT Bidprice - N * CALL Askprice ) * Multiplier > UserThreshold
3) (M * PUT1 Bidprice - N * PUT2 Askprice ) * Multiplier > UserThreshold
4) (M * CALL Bidprice - N * PUT Askprice ) * Multiplier > UserThreshold
where the "UserThreshold" can be any positive (small) amount (eg. $20).
Such pairs are automatically identified by the application, by scanning the entire option chains and finding the optimal pairs, matching the structure chosen by the fund manager. So one does not need to worry about that, apart, of course, understanding the meaning of the structure
. (I will show the automatic retrieval in detail in a next post).
<b>HOW ABOUT EXPIRATION DATES ? </b>
Expiration dates are left at the preference of the fund manager. In very general terms, my current opinion is that for the units which use the same types of options such as: +N CALL1s / -M CALL2s and -M PUT1s / +N PUT2s you generally want to pick a rather far away expiration date, because you need to give the price time to possibly travel toward the far away strike.
On the contrary, for the protection units which use calls and puts together such as: +N CALLs / -M PUTs and -M CALLs / +N PUTs you generally want to pick a closer date, for just the opposite reason.
<b> WHEN TO USE OPTIONS VERSUS THE "HEDGING ENTRIES" ? </b>
First of all, both forms of protection can be used at the same time. So one does not exclude the other one.
However, sometimes one might like to "load up" a bigger position on one direction, avoiding too much hedging and at the same time protect with options. Clearly, the possible reversal might bring in much more $$$ than the case where we allow hedging entries, which could reduce significantly the possibility to make $$$ from a reversal. It's pretty much a fund manager's preference, and it may also depend on the very nature of the instrument one is dealing with and its structural characteristics. For instance, it's not advisable to allow an inverse 2X/3X ETF to load up a big LONG, long term position, unless you have suicidal tendencies
,and so on. If instead you are hedging a short position of an instrument such as VXX, options might be an appealing choice, imho (in that case in the configuration N CALL1/M CALL2, for instance).
In case one wishes to protect an instrument with options alone, the "hedging entries" could even be disabled altogether (this is an option of the "layer settings").
<b> REAL-WORLD EXAMPLE </b>
A practical example is immediately offered by our FAS case. We had about -400 shares short that needed to be hedged. Wanting to resort to options, we might for instance choose one of the configurations 1) or 2), suitable to protect a big short position. I chose in this case +4 CALLs 85 / -8 PUTs 72. The main reason for this choice is that, in case of assignment, I prefer to deal with the problem of having 800 shares long at a lower price (after having recovered completely the current DD of the instrument), instead of having additional shares short at an higher price and more DD. (Also, if that should happen, I would probably rather move the +800 shares long resulting from assignment as a short load on an inverse instrument such as VXX, which is in practice "eaten alive" by the daily compounding effect and ETF decay, which certainly helps a lot closing short scalps). If, instead, the price remains within the 2 strikes we simply continue scalping, and we are protected "for free" (as the call options time decay is being "financed" by the puts).
<img src="http://www.elitetrader.com/vb/attachment.php?s=&postid=3907886" />
[In the next post I will explain how to automatically pick up these "option units" using the "<b>option placer</b>" within the application.]
Feel free to make questions or suggestions for improvements.
we return to our planned "OTM Profit" plus the scalp value: