Using straddels as protection

[akivak]

I'm thinking of using straddles as portfolio protection. The idea is as following:

With RUT currently at 592, sell a straddle with 2-3 strikes below the current price. For example, Feb. 570 straddle would give you downside protection of about 4%. The beauty here is that you are selling high IV, you have pretty good downside protection, but even if RUT reverses and goes up sharply, part of your loss will be offset by collapse in IV, and you might even make money.

If your outlook is for bigger drop, sell even lower straddle. The general idea is to have protection, but buying it when IV is high, so compared to buyng puts for example, it's effective and not expensive.

 

[spindr0]

There's something wrong with this picture. If you sell a straddle 2-3 strikes below current price to "protect a portfolio", effectively the ITM calls are covered by the portfolio but you've also sold naked puts which increases your downside risk. Got milk?

 

[akivak]

Quote from spindr0:

There's something wrong with this picture. If you sell a straddle 2-3 strikes below current price to "protect a portfolio", effectively the ITM calls are covered by the portfolio but you've also sold naked puts which increases your downside risk. Got milk?

I understand that. The risk profile is similar to 570 calendar. Both have maximum profit at 570 and start losing money below 570. The difference is that straddle is vega negative and calendar is vega positive. When IV is high, you want to be vega negative, so if the underlying reverses, your position benefits from IV decrease.

 

[spindr0]

Quote from akivak:

I'm thinking of using straddles as portfolio protection. The idea is as following:

With RUT currently at 592, sell a straddle with 2-3 strikes below the current price. For example, Feb. 570 straddle would give you downside protection of about 4%. The beauty here is that you are selling high IV, you have pretty good downside protection,

There's no beauty in selling high IV straddles (relatively speaking) for downside protection if the RUT has a number of 20-40 pt daily drops ala Sept 2008. IV will climb more and your position will be even worse.

... but even if RUT reverses and goes up sharply, part of your loss will be offset by collapse in IV, and you might even make money.

You might even make money? What loss? It's an opportunity loss to the upside. If you sell a underlying against the underlying, time premium received and "possible" IV drop will be a net gain.

If your outlook is for bigger drop, sell even lower straddle. The general idea is to have protection, but buying it when IV is high, so compared to buyng puts for example, it's effective and not expensive.

If your outlook is for a bigger drop, the best thing to do is get out of the way. If you can't figure out how to do that and you're concerned with cost of protection, collar the position. You need to focus more on strategy rather than the subtleties of IV.

 

[akivak]

My goal in general is hedging a long portfolio.

Of course one option is to sell everything or using a collar. I don't want to do it. I want to use an unexpensive hedge. It has to protect me against 5-7% drop (assuming I already have a black swan protection), but if the market doesn't move or moves up a little bit, I don't want to lose money as well. If it moves up strongly, the loss in the hedge should be minimal and be more than offset by the long portfolio positions.

Buying puts is not good, especially not now with high IV. Straddle might be a good option, maybe I should move it lower. Do you have other suggestions for a hedge that would suit my conditions?

 

[erol]

slingshot hedge? (from Charles Cottle)

Long stock, short 2 call verticals, use those to finance long put

(basically a butterfly with an extra OTM call)

market moves down, protected by long put

market sits still, profit from decay of short call verticals

market moves up moderately, you lose money,

market rallies, you make money

tradeoff is you reduce your delta, but you can roll the position around based on what the market is doing...

that way you get downside protection and the upside too

 

[MathAndLogic]

Quote from akivak:

I'm thinking of using straddles as portfolio protection. The idea is as following:

With RUT currently at 592, sell a straddle with 2-3 strikes below the current price. For example, Feb. 570 straddle would give you downside protection of about 4%. The beauty here is that you are selling high IV, you have pretty good downside protection, but even if RUT reverses and goes up sharply, part of your loss will be offset by collapse in IV, and you might even make money.

If your outlook is for bigger drop, sell even lower straddle. The general idea is to have protection, but buying it when IV is high, so compared to buyng puts for example, it's effective and not expensive.

Sure want to do that? You are ITM short call. Adverse price move can easily crush your gain in volatility.

 

[spindr0]

Quote from akivak:

My goal in general is hedging a long portfolio. Of course one option is to sell everything or using a collar. I don't want to do it. I want to use an unexpensive hedge.

A collar isn't an "unexpensive" hedge?

You don't want to sell everything but you're willing to sell a deep ITM call as a hedge? So that means you're willing to take the cash loss on the assigned deep ITM call if the underlying doesn't drop "X" strikes or if it moves up?


It has to protect me against 5-7% drop (assuming I already have a black swan protection), but if the market doesn't move or moves up a little bit, I don't want to lose money as well. If it moves up strongly, the loss in the hedge should be minimal and be more than offset by the long portfolio positions.

Ahh, I see. The magical, mystical black swan protection is already in place. Did you get that at no cost?

Perhaps you could explain how one would lose money with a collar if the market doesn't move or moves up a little bit?

A collar involves selling a call, usually OTM. That allows for some upside portfolio appreciation. That's no good but selling a deep ITM call is good (less time premium and no portfolio appreciation). I see.


Buying puts is not good, especially not now with high IV. Straddle might be a good option, maybe I should move it lower.

Yeh, I think you're on to something. You SHOULD sell the lowest strike straddle that you can find and protect yourself even more (eye roll).

 

[spindr0]

Quote from erol:

slingshot hedge? (from Charles Cottle)

Long stock, short 2 call verticals, use those to finance long put

market moves down, protected by long put

market sits still, profit from decay of short call verticals

market moves up moderately, you lose money,

market rallies, you make money

that way you get downside protection and the upside too

Hmmm, interesting idea. My first reaction is that at higher IV, it's not going to work that well.

In terms of IV, with verticals, whatever you receive for the call sold you somewhat pay for the call bought. As IV gets higher, the net premium received increases but not dramatically. There's a bit of an offset.

OTOH, the cost of the protective long put skyrockets as IV increases. The higher the IV, the more the cost of the entire hedge is going to be and the less attractive the hedge will be. There could be a decent loss if the underlying just sits there.

You could somewhat improve the performance in the area around the current UL price by selling a vetrtcal one strike higher but it wouldn't help the hedge much overall.

 

[erol]

Quote from spindr0:

Hmmm, interesting idea. My first reaction is that at higher IV, it's not going to work that well.

Never thought of it that way...

Do you mean higher relative IV?

Or when IV is inflated due to news announcement?