Using options for hedging purposes

[spindr0]

Quote from JuryRigged:

In periods of high volatility, spread trades are your best bet to minimize the increased cost of protection due to increased volatility.

Depending on your mid-term market outlook, you have two choices for the hedge. If you think downside risk is only going to last a short time, enter an ATM-OTM vertical put spread. This decreases the debit for the ATM put, hedges I-vol, and mutes theta decay.

Example: Long SPY Sep 120p, Short Sep 112p. Total debit 1.96 (1.63%)

If you feel downside risk is going to last a more than a month, enter a diagonal put spread, with the long leg three to four months out. Sell the OTM weeklies at your short-term downside target and roll the short leg each week (with an updated downside target).

Example: Long SPY Dec 120p, Short Sep 2 115p. Total debit 6.73

If you can generate .33 in premium for the short calls each week, you can reduce your cost basis down to about 2.00% at Dec expiration, and you'll have had the protection for three months.
You can always ratio the spread to give you more downside protection by shorting fewer calls than you are long. Or if things get really ugly, just buy to close the short calls and have complete downside protection.

If the market begins to show strength, the long-dated put can be sold to close with an excellent percentage of extrinsic value.

Obviously there's a big difference in hedging with vertcals/diagonals vs collars and there are so many possibilities that there's no simple one size fits all answer. Be that as it may, I don't think it makes much difference with vert vs collar in a high IV environment. What you overpay for the long leg, you get back from the short leg. It still ends up being the protective strategy difference rather than nickels of premium difference.

As for the suggestion to use a diagonal, I'd go with the vertical because in general with an UL collapse, its delta will rise more than that of the diag, providing better somewhat protection.

And a strike against the weeklies is that as the UL drops, in order to get that 33 cts of offset, he'll be writing successively lower strikes, potentially locking in a loss with a rally.

Obviously, there a many price possibilities so the best outcome will be determined by when the price drops as well as how much it drops.

 

[Tomaz26]

thanks for all for great content.

Here is the paper I mentioned:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1507991

It is basicaly passive 2 % OTM 6mo put + 2 % OTM 1mo call and you do get +23 % return in nasdaq bubble breakdown year. There are also different versions of getting more OTM or more ATM backtested..

What is also very interesting is active collar strategy that takes into consideration momentum, volatility and makroeconomic factors. You tighten or loosen the collar according to this data and also adjust the numbers of calls sold(0.75, 1 or 1.25) ..
The return from 1999-2010 is 12 % yearly with this strategy compared to -0,3 % yearly beeing long underlaying. Also volatility is drasticaly lower.

I am very excited about implementing this strategy and would be very glad if someone could maybe look at it and give more realistic look. I am risk averse so I search for some strategy to limit drawdowns and volatility so I think collars could work great for me. On the other hand 1999-2010 is not very long timeframe, so some more backtesting should be done.

Spindro: what strategies do you use?

thanks again to all

 

[joneog]

Quote from Tomaz26:

thanks for all for great content.

Here is the paper I mentioned:
...

As a general rule I discount academic papers discussing trading/investing strategies. A lot of things look great on paper or in hindsight, it's quite different in a dynamic/fluid situation where you have to deal with all the real-world issues of spreads, fees, slippage, liquidity, errors, emotions etc. etc.

Over the years there have been numerous papers showing how you can do X or Y and get Z return but when some of the assumptions are examined in the real world they tend to fall apart. It's futile to examine a particular period in market history(however comprehensive) and simply extrapolate it into the future.

I'm not saying collaring won't work but like any strategy it mostly depends on timing and the situation. When that's the case, and you don't have a ton of experience w/ derivatives, you're generally better off timing the market in the simplest way possible (directionally in the underlying) to avoid as many b/a spreads, fees, and user-errors as possible. If you are uncomfortable with the risk adjust your allocations/betas. just my .02

 

[atticus]

Quote from Tomaz26:

Thanks for suggestions. I found a very good paper testing different collars for QQQ from 1999 to 2010 with very good results. This strategy of course trails returns in bull market(returning 5-7 % yearly instead of 21 %) but really shines in nasdaq decline in 2000 and also very good returns from 2007-2010 ! For example in declining years you get +23 %. I must read the paper again in details because I am not sure how you can get so drasticaly better return in declining years. I though with collar you cannot earn much but you also cannot loose much. I think the strategy was buying 6 month puts and monthly selling 1 month out calls. All in all you get more than 1/2 lower volatility with nice yearly returns. I think now after such spectacular run-up in 2 years it is time for this strategy. I guess the only time not to hedge like that is after 50+ % sell-offs after recessions etc.

thanks

A collar is a synthetic bull vertical, so it will perform poorly in a bear market, albeit not as poorly as outright shares. That 23% figure is pure bullshit.

 

[Tomaz26]

Quote from atticus:

A collar is a synthetic bull vertical, so it will perform poorly in a bear market, albeit not as poorly as outright shares. That 23% figure is pure bullshit.

Hmm, could be but I really doubt they would publish the paper without backtest or some kind of proof to back it up. They certainly could not came with this number out of the thin air. I do not have the knowledge to test the strategy but surely many people do and I doubt they would just write some numbers.. After all, this is not some investment advice selling service where people publish all kinds of nonsense just to get customers. Authors don`t earn anything from this(at least not directly) and since the papers is freely accessible to the wide public I am having a hard time believing they just published some non prooven nonsense.

Of course collars are nothing magical, after all the stretegy trails returns from 2002-2007 a lot, but since I do not thing we are facing 2002-2007 scenario. Much more probable would be another 2007-2010 or even 1999-2002 if liquidity flood continues.. In both cases stretegy seems to be doing great.

I would be greatfull if someone could backtest or proove this is bull.. instead of just saying it.

anyway thank for comment

 

[atticus]

Quote from Tomaz26:

Hmm, could be but I really doubt they would publish the paper without backtest or some kind of proof to back it up. They certainly could not came with this number out of the thin air. I do not have the knowledge to test the strategy but surely many people do and I doubt they would just write some numbers.. After all, this is not some investment advice selling service where people publish all kinds of nonsense just to get customers. Authors don`t earn anything from this(at least not directly) and since the papers is freely accessible to the wide public I am having a hard time believing they just published some non prooven nonsense.

Of course collars are nothing magical, after all the stretegy trails returns from 2002-2007 a lot, but since I do not thing we are facing 2002-2007 scenario. Much more probable would be another 2007-2010 or even 1999-2002 if liquidity flood continues.. In both cases stretegy seems to be doing great.

I would be greatfull if someone could backtest or proove this is bull.. instead of just saying it.

anyway thank for comment

Do you need a back rub? Fetch your slippers for you? I don't need to cherry-pick a backtest like in your dubious paper to know definitively that a BULL VERTICAL is not going to return 23% in a bear-market that saw a >60% loss peak to trough.

It's outright BS or cherry-picked.

 

[spindr0]

Quote from Tomaz26:

It is basicaly passive 2 % OTM 6mo put + 2 % OTM 1mo call and you do get +23 % return in nasdaq bubble breakdown year. There are also different versions of getting more OTM or more ATM backtested..

What is also very interesting is active collar strategy that takes into consideration momentum, volatility and makroeconomic factors. You tighten or loosen the collar according to this data and also adjust the numbers of calls sold(0.75, 1 or 1.25) ..
The return from 1999-2010 is 12 % yearly with this strategy compared to -0,3 % yearly beeing long underlaying. Also volatility is drasticaly lower.

As I mentioned in my previous reply, in order to get a 23% return, they'd have to be doing some amount of timing and/or legging and/or ratioing, and most likely, getting some favorable bounces. Using momentum, volatility, macroeconomic factors and ratioing the calls is just that. Atticus is correct, from straight verticals, it's BS. From timing and adjusting, anything is possible since that's a different set of skills added on.

 

[spindr0]

Quote from atticus:

Do you need a back rub? Fetch your slippers for you? I don't need to cherry-pick a backtest like in your dubious paper to know definitively that a BULL VERTICAL is not going to return 23% in a bear-market that saw a >60% loss peak to trough.

I don't care much for the backtesting but a massage would do nicely... just not from a hard ass like you

 

[Tomaz26]

Quote from atticus:

Do you need a back rub? Fetch your slippers for you? I don't need to cherry-pick a backtest like in your dubious paper to know definitively that a BULL VERTICAL is not going to return 23% in a bear-market that saw a >60% loss peak to trough.

It's outright BS or cherry-picked.

There there. Now that you say it this way, I am convinced that this research paper is just a load of crap. Can`t argue with your strong arguments and facts.. Surely some on-line forum guru will know better than a bunch of guys with their fancy PHDs..

 

[Tomaz26]

Quote from spindr0:

As I mentioned in my previous reply, in order to get a 23% return, they'd have to be doing some amount of timing and/or legging and/or ratioing, and most likely, getting some favorable bounces. Using momentum, volatility, macroeconomic factors and ratioing the calls is just that. Atticus is correct, from straight verticals, it's BS. From timing and adjusting, anything is possible since that's a different set of skills added on.

Well you are correct, they also test the active collar strategy with much better returns, but the returns of 23 % are from the passive strategy. See the attached picture about the performance ob 2 % puts and ATM to 5 % OTM calls.