Author Topic: Anybody hedging with options?  (Read 1618 times)

ChpBstrd

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Anybody hedging with options?
« on: July 25, 2017, 04:14:21 PM »
Valuations are high, tech unicorns are inflating the market, trade barriers are going up, and interest rates are likely to rise in the next year. Meanwhile, volatility is low and options are cheap. Seems like a good time to protect one's portfolio while staying fully invested.

Here's the idea:
1) ~90% of my equity allocation in SPY at $247.40.
2) Purchase December 20, 2019 put options at the 250 strike price for around $24.68/share.

The price of the put represents 10% of the money protected and the duration of the protection is 877 days, or 2.4 years. This works out to a cost of 4.17% per year. Upside is not limited. The strike price is 1% higher than I'm paying for the stock, so the adjusted cost of 100% investment insurance for 2.4 years is 10%-1%=9%.

(I'm not accounting for the opportunity cost of the options premium because the riskiness or beta of my protected portfolio is probably similar to or greater than what I'd be comfortable with unprotected.)

Also, SPY pays a dividend of 1.87%/yr. Across 2.4 years, that's roughly 4.49%.

So over 2.4 years, my maximum loss is the -10% put premium, plus the 1% minimum profit on option exercise, plus about 4% dividends (assuming minor dividend cuts during a recession/crash) = -5%. My maximum gain over those 2.4 years is infinity minus 5%.

If I set up this portfolio and the stock market continued to climb, I would lag its performance by about 2.08% a year - which doesn't seem a high price to pay for having a 5% max downside in the current environment. 10y bonds aren't even that safe.

If I set up this portfolio and the stock market lost 40% 25%, etc. (pick your favorite scary number), I would only lose my maximum 5%.

FWIW, I'm 6 years to FIRE if I can average around 7% ROI during that period. However, the math says a market accident could add 2-4 years to that timeframe, which is the risk I'd like to hedge! In the event of an actual big correction, I would probably sell the puts gratefully and remain passively invested.

Is anyone else looking at a similar hedging setup? Have you found a less costly way to do it? Do you agree the price of protection is low right now?

eudaimonia

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Re: Anybody hedging with options?
« Reply #1 on: July 25, 2017, 04:53:23 PM »
I agree with your math and relatively speaking SPY options are very cheap at the moment (except for deep out of the money due to the steepness of the put skew curve).

Just keep in mind that old (and strong) bull markets like we are currently in don't immediately turn into crazy bear markets like 2008. The odds are the premium seller will make money off you (just like the insurance on your house). If this helps you keep invested and sleep at night then it may be worth the price.

L.A.S.

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Re: Anybody hedging with options?
« Reply #2 on: July 25, 2017, 06:32:51 PM »
I dunno.  If you ask me, it seems like you've just flushed 10% of your portfolio (or of the stock portion of your portfolio) down the tubes if your prediction of a market collapse in the next 2.5 years doesn't occur.  I think it is an error of judgment to justify the loss as being only 5% due to the S&P paying dividends.  Dividends are part of the overall return of stocks.  And, I don't quite understand the "1% minimum profit on options exercise" either.  If you don't exercise the options, then I don't see how you can count this. 

bender

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Re: Anybody hedging with options?
« Reply #3 on: July 25, 2017, 09:47:16 PM »
Following. 

I'm working on a similar strategy but selling shorter term out of the money calls.  I limit my upside in the short term, but collect premiums which is nice.  in also only doing this with a small part of my portfolio.

jjcamembert

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Re: Anybody hedging with options?
« Reply #4 on: July 26, 2017, 02:55:55 PM »
The cheapest way to hedge is to sell some stock. For every ATM put you're looking at selling 50 shares of stock.

Those 250 puts are the most expensive (relatively) options you can buy. It seems like you're concerned about a big move, so why not buy something with less intrinsic value? The 1 standard deviation, Dec 190 puts are only $7.

Another way of reducing your cost while adding downside protection would be to sell another option against your long option, either as a put spread or a put diagonal. This will provide you some downside protection but it will be limited to the width of the strikes. E.g. Buy the Dec 265, Sell the Dec 225. The difference in intrinsic is about $1.50, so you would actually make money if SPY went nowhere by 2019. But in this case you'd only be protected down to 225. But of course you can set up different trades to have a variety of protection levels to your preference.

My preference would be to change the stock into naked puts or sell calls against the stock. But I understand this isn't always preferable in taxable accounts.

yoda34

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Re: Anybody hedging with options?
« Reply #5 on: July 26, 2017, 03:15:31 PM »
I was looking at the Jul 18 spy puts today. At one point they hit about 5% and I've been thinking long the same lines as you. Max loss of about 3.3% with unlimited upside.

I do have a question about your calculation of only lagging the index by 2% a year. If the SPY stays above the strike, don't you lag the overall index by 10% over the 2.5 years?

ChpBstrd

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Re: Anybody hedging with options?
« Reply #6 on: July 26, 2017, 09:16:16 PM »
I was looking at the Jul 18 spy puts today. At one point they hit about 5% and I've been thinking long the same lines as you. Max loss of about 3.3% with unlimited upside.

I do have a question about your calculation of only lagging the index by 2% a year. If the SPY stays above the strike, don't you lag the overall index by 10% over the 2.5 years?
That 2% was a typo on my part. I switched the strike price or date in the middle of typing and didn't change all numbers. Oops.

If markets are higher than the strike price in 2.4 years, I would lag by 10%, or 4% per year. So, for example, if the market gains 10% a year for the next 2.4 years, or 24%, my net capital gain over that timeframe would be 24%-10%=14%, not including dividends.

If markets are lower than the strike price, my return would have a -9% floor, no matter how low the market goes (because I paid 10% for the option and exercised it to sell my stock for 1% more than I paid).

You're looking at one-year duration. I'm looking at 2.4 years duration. I'm considering paying 10% for an 2.4 year option that is 1% in-the-money. The cost of this insurance is *roughly* 10%/2.4y = 4% per year.

If the market stays above the strike price, I would actually lag the total return by about 4% per year, or 10% over 2.4 years.

bender

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Re: Anybody hedging with options?
« Reply #7 on: July 26, 2017, 09:42:08 PM »
The problem is if the market goes sideways, in the range of +0 to +15% total over the 2.4 year period.  In the 0% case it seems your losses will total close to 9%, and with +15%, you Only make 5% in 2.4 years.

ChpBstrd

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Re: Anybody hedging with options?
« Reply #8 on: July 27, 2017, 12:52:30 PM »
The problem is if the market goes sideways, in the range of +0 to +15% total over the 2.4 year period.  In the 0% case it seems your losses will total close to 9%, and with +15%, you Only make 5% in 2.4 years.
That's correct from a capital gains perspective, but my total return includes dividends. Add 4.5% to the numbers above to convert them to total return over 2.4y. It's not much gain, but not much pain either.

Speaking of the importance of dividends...

If I could get the put protection for cheaper, I'd have an all-weather winner. So I'm now looking at how to use a synthetic short (buy a put, sell a call) to hedge a long position more cheaply. However, since a portfolio containing shares plus a synthetic short is simply guaranteed to go nowhere, I'll look at doing it with high-dividend stocks such as mortgage aggregators, BDCs, or MLPs in order to get the dividend risk free. Example: NLY yields over 10% and has an options market. If I could earn a net 7% or more while fully or mostly hedged against capital losses, I'd be happy to lock in such a deal and coast to FIRE anxiety-free.

ChpBstrd

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Re: Anybody hedging with options?
« Reply #9 on: July 27, 2017, 01:02:32 PM »
Here are some other options to think about:

1. Sell out of money put options instead.  If the market doesn't crash, you make a small profit.  If it does crash, you are "stuck" with shares that are lower than what you could buy on the market today (if you did this with SPY, you'd be getting the entire market at a lower Shiller PE ratio).  Buffett does this when he wants to buy something.

2. If you are 100% invested in stocks/real estate, sell and buy 10-20% bonds / cash.  In a stock market crash, the fed cuts rates and/or performs quantitative easing, so bonds should go up, and cash could be used to buy stocks / real estate at firesale prices.
With #1, yes, that is the correct way to buy stocks. It's always nice to start a position in the green. Doing this every month in the SPY (and selling calls after being assigned) can earn you ~9% annualized. However, selling puts comes with infinite loss potential. A lot of bad news can happen in 30 days, and as a put seller, you're highly leveraged to the downside.

Re: #2 this is good advice for expensive markets in general, but offers only minor protection in the event of a large correction. Losing 30% instead of 35% helps, but...

respond2u

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Re: Anybody hedging with options?
« Reply #10 on: July 28, 2017, 09:16:17 PM »
This is the tactic laid out in https://seekingalpha.com/article/4090479-time-put-all-in (also published 7/25 :)

There are comments in the thread that call to question the accounting of dividends and whether you should go to the bother of creating a synthetic call (buy SPY + buy put) instead of just buying a call.


ChpBstrd

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Re: Anybody hedging with options?
« Reply #11 on: August 01, 2017, 08:29:04 AM »
Here are some other options to think about:

1. Sell out of money put options instead.  If the market doesn't crash, you make a small profit.  If it does crash, you are "stuck" with shares that are lower than what you could buy on the market today (if you did this with SPY, you'd be getting the entire market at a lower Shiller PE ratio).  Buffett does this when he wants to buy something.

2. If you are 100% invested in stocks/real estate, sell and buy 10-20% bonds / cash.  In a stock market crash, the fed cuts rates and/or performs quantitative easing, so bonds should go up, and cash could be used to buy stocks / real estate at firesale prices.
With #1, yes, that is the correct way to buy stocks. It's always nice to start a position in the green. Doing this every month in the SPY (and selling calls after being assigned) can earn you ~9% annualized. However, selling puts comes with infinite loss potential. A lot of bad news can happen in 30 days, and as a put seller, you're highly leveraged to the downside.

Re: #2 this is good advice for expensive markets in general, but offers only minor protection in the event of a large correction. Losing 30% instead of 35% helps, but...

Selling puts does NOT have infinite loss potential.  Technically if you sell a put and the company goes bankrupt, you only lose the amount at the strike price times the number of shares e.g. a finite number.  And if you do it on the SPY, we'd have bigger problems if the entire S&P 500 went bankrupt - that would be guns and ammo time.  Also, if you sell a put on SPY at a price you believe is rational, if you get stuck with SPY at that price, you only lose if you sell right away.  You can always hold the S&P 500 until it recovers, which it is likely to do quickly in the event of a huge crash.  The only scenario that would lose would be a Japan scenario where it crashes and stays down for many years.
You are correct. Stocks can only go down to zero, which is not infinite. So if I sell one put contract on a $100 stock which subsequently goes to zero, I can lose no more than 100 100 = 10,000 which is what I'd be obliged to pay for something with zero value in that scenario. Enron and Bear Stearns come to mind as blue-chip examples of how selling $100 worth of puts could lead to tens of thousands in losses.

ChpBstrd

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Re: Anybody hedging with options?
« Reply #12 on: August 01, 2017, 08:50:02 AM »
Looking at 2 additional possibilities now.

1) DSL is a closed end fund yielding over 8% and paying monthly dividends. One could currently set up a 199 day synthetic short on DSL at the 20 strike (current price $21.36) and get paid about a $0.90 credit per share for doing so. 3 months of $0.15 dividends would erase the remainder of the risk in the trade. At that point, you'd be locked into a profit regardless of what the markets did. The size of the profit would depend on whether you got executed early.

2) Junk bonds from Navient Corporation (NAVI) and Ferrellgas (FGP) can be bought with double-digit yields, but come with the risk of default. However, way-out-of-the-money long-duration puts at the 2.50 or 5 strikes can be bought for a few cents per share. The value of these puts would multiply in the event of a default on the bonds / bankruptcy. It seems like one could hedge the bonds to some extent by buying the really cheap puts on the stock. A $10k bond investment hedged by puts at the $5 strike could be hedged with about 20 put contracts. Has anyone done anything like this?

runewell

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Re: Anybody hedging with options?
« Reply #13 on: August 01, 2017, 09:04:19 AM »
I wouldn't put 90% of my portfolio into SPY.
Please leave Dicey out of this! Have you not been paying any attention? Trolls are not welcome here!

bender

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Re: Anybody hedging with options?
« Reply #14 on: August 01, 2017, 10:42:39 AM »
NLY is a REIT.  This class of stock must return 90% of their profit to shareholders as dividends.  Note these are usually non-qualified.  This particular REIT is one of the largest and has returned 10%+ dividends for many years.  On the other hand - the price hasn't moved much in 20 years.

ChpBstrd

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Re: Anybody hedging with options?
« Reply #15 on: August 02, 2017, 09:09:24 PM »
 ^ The put option would guarantee that I could sell NLY at the strike price of the put, no matter how far it fell.

bender

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Re: Anybody hedging with options?
« Reply #16 on: August 03, 2017, 11:13:17 AM »
My response was just explaining the REIT to the other poster.  Your idea to limit the return to 7% with a downside hedge is valid.  Have you investigated the price and term of the puts? 

The Oct 20 puts would allow you to collect the ~0.30 dividend in September and then sell if the stock drops.  The $11 put limits your loss to about 9%, for the cost of ~0.10.  This eats about 1/3 of the yield, which gets you the 7% return your looking for.  Unfortunately it's not risk free, there is still 9% downside risk.  Not worth it I think.

gluskap

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Re: Anybody hedging with options?
« Reply #17 on: August 03, 2017, 02:53:22 PM »
I understand you're ready to FIRE in 6 years but you will not be taking out your full portfolio in that time.  You will still be retired for a long time period (probably 30 years at least depending on your life expectancy).  Why not just keep everything in stocks without any options?  Let's say stock market does go down in the next 2.5 years...so what?  Your losses are just paper losses unless you sell.  In the long term they will go back up like it always does.  Even if you did decide to retire in the next 2.5 years you would only be taking a loss on the amount you withdrew for that year's living expenses which if you are truly Mustacian isn't really that much?  Am I missing something?

ChpBstrd

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Re: Anybody hedging with options?
« Reply #18 on: August 03, 2017, 03:27:14 PM »
^ The put option would guarantee that I could sell NLY at the strike price of the put, no matter how far it fell.

I get it, the put protects the downside, while you sell a call to get premium to partially pay for it.

I've been running the numbers today on this trade with NLY and haven't been able to find a combination of buy NLY long, buy put, and sell call that equates to a risk free 7% return yet.  Please let me know what your strike price and strike dates are.

Part of the problem is we're talking about a moving target. I don't see any attractive arbitrage opportunities with NLY today either. When the shares move a few cents, am ex-div date passes, or the strike goes from ITM to OTM, any potential setup disappears. Time decay moves the prices around daily. This is a hard topic to make sense of in a forum.

I'm currently (8/3/2017, after market close) looking at DSL, a closed end fund yielding 8.38% and priced at $21.25. At the Feb 16 '18 $20 strike, you can sell a call for about $2.90 (based on mark and theoretical prices) and buy a put for $0.50. The $2.40/share credit you would be paid to establish the synthetic short would make up for the $1.25 capital loss from getting called and having to sell shares at $20. The rest of the credit, $1.15, represents an immediate annualized ROI of (1.15/21.25)/(197 days/365 days)=10%.

Then you also get to collect a $0.15 dividend per month. If you were able to collect 6 out of 7 months' dividend before getting called, that would be an extra $0.90, or (0.9/21.25)/(197/365)= 7.8%.

I'm open to the possibility I'm doing the math wrong, so please correct me if I'm goofing up something.

Panly

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Re: Anybody hedging with options?
« Reply #19 on: August 04, 2017, 12:35:41 PM »

I hedge market risk with SPX puts.


It's been a painful affair in the last 6 years,  need quite a sudden crash in order to break even.

I would advise against waiting 2,4 years before rolling over your put position, as your downside protection becomes smaller over time, all else equal.



ChpBstrd

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Re: Anybody hedging with options?
« Reply #20 on: August 04, 2017, 01:41:44 PM »

I hedge market risk with SPX puts.


It's been a painful affair in the last 6 years,  need quite a sudden crash in order to break even.

I would advise against waiting 2,4 years before rolling over your put position, as your downside protection becomes smaller over time, all else equal.

I'm thinking hard about putting it all in SPY and then applying a collar strategy. That's cheaper than a protected put strategy. For the price of 1.9% (1.3% annualized), I can constrain my returns to +/- 9% plus a couple % in dividends between now and January 2019. You might make that cheaper by selling the calls each month, rather than selling a single long-duration call, and letting accellerated time decay work in your favor.

This is not a bad gamble given the metrics these days. It is, however, interesting how much more expensive puts are compared to calls right now. In a normal market, calls are more expensive. Are options bearishly biased right now?

This observation makes me wonder if instead of hedging a long stock position, I should just cash out and buy ATM calls with maybe a tenth of my portfolio. The leverage would be the same as a 100% stock position, but only a tenth of my portfolio would be at stake. The price of such an option is about 8% of the stock's price, but if the market doesn't rise that much in 2.4 years, it will probably be for a reason that makes you grateful to have bought the call instead of the stock.


jjcamembert

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Re: Anybody hedging with options?
« Reply #21 on: August 07, 2017, 10:43:15 AM »

I'm thinking hard about putting it all in SPY and then applying a collar strategy. That's cheaper than a protected put strategy. For the price of 1.9% (1.3% annualized), I can constrain my returns to +/- 9% plus a couple % in dividends between now and January 2019. You might make that cheaper by selling the calls each month, rather than selling a single long-duration call, and letting accellerated time decay work in your favor.

This is not a bad gamble given the metrics these days. It is, however, interesting how much more expensive puts are compared to calls right now. In a normal market, calls are more expensive. Are options bearishly biased right now?

This observation makes me wonder if instead of hedging a long stock position, I should just cash out and buy ATM calls with maybe a tenth of my portfolio. The leverage would be the same as a 100% stock position, but only a tenth of my portfolio would be at stake. The price of such an option is about 8% of the stock's price, but if the market doesn't rise that much in 2.4 years, it will probably be for a reason that makes you grateful to have bought the call instead of the stock.

Puts are almost always more expensive in the stock market because volatility will increase to the downside. Gold on the other hand typically has inverse skew where calls are more expensive.
https://www.dough.com/blog/volatility-skew

I'm thinking the other problem with just buying calls is you won't get any dividends. I don't know that much about how dividends are priced into calls, other than that people will typically exercise calls if the intrinsic value is less than the dividend. When you're short a put though I believe the dividend is priced in. More info here: http://www.investopedia.com/articles/optioninvestor/03/121003.asp

Not sure if this is a taxable account or not but if so SPX would typically have better tax treatment than SPY, but it's 10x larger.