Author Topic: Option question for hedging portfolio  (Read 1064 times)

GoCubsGo

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Option question for hedging portfolio
« on: February 06, 2021, 10:08:56 AM »
Dumb question for all you option folks in the forum:

Due to some skill and a lot of luck, I've had huge gains the last few years (like many have).  I'm to the point where I'm far ahead of my previous FIRE schedule (2-4 years away). I really only need 4% returns over the next couple years to get to my fat FIRE number.  I've never dabbled in options but I do have a question about using them as a hedge. I've been working through some thoughts. Here's the setup:

If I'm worried about protecting my big recent gains, I see a couple different paths in case of a large correction or a protracted bear market:

    1.  Move a substantial portion of my portfolio NOW to bonds (like 50%) and hope rising rates don't screw me. Basically start a move         
         to a bond tent. I don't love this option as I'm skittish about bonds going forward.
    2.  Keep my current allocation (85/15) and set a target to re-allocate to cash if the market drops "X %".  Basically market time and 
         sell out of my heavy tech positions and move that to cash.  I've sorta already won so why risk my portfolio so
         close to FIRE.  Ride it for awhile and be prepared for a big move to cash.  Re-allocate to stocks over the ensuing years.
    3.  Options-  I've heard of hedging a portfolio the long dated options (Long put?).  I'm thinking a year out and I understand that it
         could expire worthless which is fine and would factor those losses in.  Figuring out how much to hedge and how much I'm willing
         to lose to pay for that security is where I'm totally confused and don't know where to start.  Maybe it's too complicated and not
         worth pursuing?

Basically, I am set for regular FIRE right now with some budget changes.  A big loss, followed by a prolonged bear market is the only thing that can really screw me up in regards to planning for a FIRE date.  A large market drop followed by a prolonged slump could move my FIRE date back 10 years. 

A FIRE date is such an arbitrary number based on a "moment in time" so I definitely want to use a conservative SWR.   I'm a perma-bull and the thought of de-risking feels weird.  That said, I feel like the market has given me a real gift the last few years and seeing that evaporate would really suck.

Any thoughts on hedging an entire portfolio using options (or other critiques on my plans) would be appreciated. 

MustacheAndaHalf

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Re: Option question for hedging portfolio
« Reply #1 on: February 06, 2021, 10:59:31 AM »
I haven't seen a bond tent that drops from 85% to 50% equities in one year, nor one that starts 2-4 years before retirement.  There's some interesting research on bond tents that might be a more comfortable approach than what you're considering.

When I've looked at PUT options to protect against index losses, the downsides have kept me from buying.  On the $388 SPY (S&P 500), you can buy PUTs at $310, $350, or $388.. but it costs 3%, 6%, or 9% of the stock price for 1 year.  Stocks mostly go up, so PUTs mostly lose value - and expire worthless, if held that long.

If you do have a loss, and the PUT has value... when do you use it?  It's a market timing decision, deciding when the bottom has hit.  Use it early, and it does nothing against a following drop.  Use it too late, and you paid for protection you didn't use in time.

frugal_c

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Re: Option question for hedging portfolio
« Reply #2 on: February 06, 2021, 01:35:46 PM »
I prefer cash and more defensive stocks to puts.

maizefolk

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Re: Option question for hedging portfolio
« Reply #3 on: February 06, 2021, 02:24:52 PM »
Since you say you really only need 4% per year in investment returns going forward I believe you could offset part of the cost of buying puts by selling covered calls on your position at 4% above their current value. If you're looking out three years you could sell the covered called at $440 for the S&P 500 for about 7.2% of your investment's current value, and then use that to purchase puts, which (close to three years out, December 2023) would let you buy the $295 S&P 500 put. If you aim for the same thing over one year, you could sell the $405 covered call on SPY for 5.6% of your investment. That limits your maximum upside to 4% per year over three years and your maximum downside to -8.3% per year over three years. I tried running the same numbers looking out only a year (January 2022), and limiting your upside to 4% was enough to pay for limiting your downside to -11%.

Neither sounds like an appealing trade-off to me. But insurance, which is basically what this would be, is almost always the same equation, reducing your expected value in exchange for taking the worst possible outcomes off the table. Only you can decide if that cost is worth the reduced uncertainty.

Others who know more about options may be able to point out something I'm missing here.

GoCubsGo

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Re: Option question for hedging portfolio
« Reply #4 on: February 06, 2021, 03:02:03 PM »
Thanks all,

Maizefolk.. some of reading I've done has recommended doing something similar to what you've proposed.  The ability to figure out the upside vs downside is really the difficult part for a options newbie (thank you for taking the time to look at that).  I know financial advisors sell pre-packaged options based products that do some of this.   My buddy actually sold for a company that offered a similar product directly to financial advisors. 

I can't imagine I'm the only one who is worried about this given the high CAPE ratio and the massive run up we've seen since March.
I'd also think it would definitely have some value in maybe mitigating sequence risk for those first few years of retirement.  That said, I'm probably overthinking it, but I keep having a nagging feeling that a large bond allocation won't make me very comfortable.

Also, I would guess we get we will have a 10-12% correction at some point this year.  Buying a SPY put may be something I look into regardless and treat it as any other investment I own. 
« Last Edit: February 06, 2021, 03:04:09 PM by GoCubsGo »

maizefolk

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Re: Option question for hedging portfolio
« Reply #5 on: February 06, 2021, 03:50:33 PM »
I can't imagine I'm the only one who is worried about this given the high CAPE ratio and the massive run up we've seen since March.
I'd also think it would definitely have some value in maybe mitigating sequence risk for those first few years of retirement.  That said, I'm probably overthinking it, but I keep having a nagging feeling that a large bond allocation won't make me very comfortable.

Nope, you are definitely not the only one who is worried. Can say that both from reading the forum and because of how surprisingly high the cost of long dated puts turned out to be.

If it helps any (it may not), the way I look at it we could have a significant correction, in which case puts and/or bonds would be a great investment. Or we could have significant inflation, and stocks would be a much better long term investment than bonds or put based “insurance”.

For me at least it helps to remember that the weird unsettled feeling in my gut as the stock market continues to climb in the current environment could be completely right and that STILL wouldn’t mean I’d know what to do with my investments.

frugal_c

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Re: Option question for hedging portfolio
« Reply #6 on: February 07, 2021, 09:00:39 AM »
Selling calls to buy the puts is risky.  The markets move up double digits for years and then flat or down.  If you are capping the upside there is a real chance you will not get the 4% return you are after.

Financial.Velociraptor

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Re: Option question for hedging portfolio
« Reply #7 on: February 07, 2021, 11:41:41 AM »
Selling covered calls to fund long puts is called "collaring" a position.  Bernie Madoff famously convinced a lot of rich people that he could consistently earn 12% a year on their money by using a collar strategy.  The idea was absurd.

Either way, buying puts is a lot like paying an insurance premium.  Unfortunately, the market has a lot of implied volatility right now so those premiums are a lot higher than normal.  I am selectively putting a thousand here and there into long dated puts on highly leveraged companies that I expect to fall further and faster than most when the correction(s) come.  Currently 11 out of 11 open positions are in the red.  If you do this, expect to be wrong and do it to sleep better at night.

If you are new to options, long puts are a horrible way to get started.  I suspect you are better off adjusting your asset allocation.  In my experience market nerves always mean the investor has too little cash and/or bonds.  I'm currently looking to tilt as cash becomes available into more closed end municipal bond funds.  There are several good ones that yield a little over 4.5% fed tax free right now.

GoCubsGo

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Re: Option question for hedging portfolio
« Reply #8 on: February 08, 2021, 10:14:43 AM »
  I suspect you are better off adjusting your asset allocation.  In my experience market nerves always mean the investor has too little cash and/or bonds.

@Finacial.Velociraptor-  Thanks for chiming in, I checked in on your blog multiple times and I appreciate your thoughts.  That said, would you feel comfortable moving a significant chunk of a large portfolio into bonds over the next year or so (bond tent)?  I will admit my AA is out of wack at the moment due to the tech runup and I don't really love the thoughts of bonds.  I guess cash would be my only option if I really think about it.  Rising interest rates can't be good for bonds (rates have to rise over the next 5-7 years right?) and if I need to reduce sequence risk I'd imagine cash is probably best for me over that time period.

frugal_c

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Re: Option question for hedging portfolio
« Reply #9 on: February 08, 2021, 11:19:47 AM »
Bonds are generally only dangerous if you have fixed rate and longer duration. If you have variable or short duration it's fine. I mean you aren't getting hardly any yield but still it's fine from risk of loss perspective.

ChpBstrd

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Re: Option question for hedging portfolio
« Reply #10 on: February 08, 2021, 11:42:46 AM »
Since you say you really only need 4% per year in investment returns going forward I believe you could offset part of the cost of buying puts by selling covered calls on your position at 4% above their current value. If you're looking out three years you could sell the covered called at $440 for the S&P 500 for about 7.2% of your investment's current value, and then use that to purchase puts, which (close to three years out, December 2023) would let you buy the $295 S&P 500 put. If you aim for the same thing over one year, you could sell the $405 covered call on SPY for 5.6% of your investment. That limits your maximum upside to 4% per year over three years and your maximum downside to -8.3% per year over three years. I tried running the same numbers looking out only a year (January 2022), and limiting your upside to 4% was enough to pay for limiting your downside to -11%.

Neither sounds like an appealing trade-off to me. But insurance, which is basically what this would be, is almost always the same equation, reducing your expected value in exchange for taking the worst possible outcomes off the table. Only you can decide if that cost is worth the reduced uncertainty.

Others who know more about options may be able to point out something I'm missing here.

I like collars. They worked great for me in 2018 and 2020. The market's volatility right now is too high to make them a bargain. As you noticed, option prices are skewed toward puts. Wait for VIX to get down to the 15-16 range and check again!

What OP wants is upside potential plus a floor on losses - a returns function shaped like a hockey stick. Another way to do this is to replace one's stocks with a rolling portfolio of long-duration call options. Because calls cost less than stocks, this leaves the majority of one's portfolio to invest in short-duration bonds or other safe, low-yielding assets. The issue is that like all leverage this costs some money. Expect to lose 2-3% to time decay per year, compared to an all-stock portfolio. This is the price one pays to offset the risks, but in return you get a portfolio that cannot blow up. That drag nags the nerves of most investors on this board, but it has historically been a fair deal. Options are priced fairly, by supercomputers, so you're getting what you pay for.

In another thread, we're discussing what it would look like to buy even more calls and have 2 or 3x leverage.

Financial.Velociraptor

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Re: Option question for hedging portfolio
« Reply #11 on: February 08, 2021, 05:07:10 PM »
  I suspect you are better off adjusting your asset allocation.  In my experience market nerves always mean the investor has too little cash and/or bonds.

@Finacial.Velociraptor-  Thanks for chiming in, I checked in on your blog multiple times and I appreciate your thoughts.  That said, would you feel comfortable moving a significant chunk of a large portfolio into bonds over the next year or so (bond tent)?  I will admit my AA is out of wack at the moment due to the tech runup and I don't really love the thoughts of bonds.  I guess cash would be my only option if I really think about it.  Rising interest rates can't be good for bonds (rates have to rise over the next 5-7 years right?) and if I need to reduce sequence risk I'd imagine cash is probably best for me over that time period.

@GoCubsGo Thanks for being a reader!

I have some individual bonds bought at distressed prices.  More speculation than Asset Allocation.  For my bond allocation I prefer alternatives to conventional bond indexes.  These would be closed end funds (especially those in tax exempt municipals like IQI and NEA), preferred shares, and convertible bond funds.  The broad indexes for bonds have no yield and that is going to end badly.  You can get 4%+ yield by getting a little unconventional while still reducing your risk.  You can scan the universe of closed end funds here: https://www.cefconnect.com/closed-end-funds-screener  (Make sure to only buy at a discount to NAV and never a premium).

MustacheAndaHalf

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Re: Option question for hedging portfolio
« Reply #12 on: February 08, 2021, 11:39:35 PM »
@Financial.Velociraptor - Side note, on your website you use terms that a new visitor might not understand.  Many news sites, Wikipedia and Investopedia use the technique of providing a link to explain special phrases.  You could do something like that, linking to your explanation, and probably keep more visitors on your site.  Feel free to ignore the idea - just thought it might help.

@ChpBstrd - On the long-duration call options - it might only work with deep in the money calls.  Going for 5x leverage at a strike 15.5% below the current SPY price means accepting 6.5x leveraged losses: the option loses 100% of it's value after a 15.5% drop.  There may also be price changes in call options near a crash, where 3x leveraged call options might take more gains before they catch up to stocks.  Your warning in another thread is worth repeating: 3x leverage of 0% is still 0%, but the call options have costs that make it not break even in a sideways market.

yoda34

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Re: Option question for hedging portfolio
« Reply #13 on: February 11, 2021, 12:21:50 PM »
I'll add one strategy I haven't seen here yet. When options prices are too high for a collar (like now) I use a capped ratio spread that gives me the same protection at an acceptable cost. Glad to go into details if others haven't seen that used before. Right now I have a 100% hedge where I can lose at most 10% that expires in December 2021 that cost me about 1.5% to put on.

ChpBstrd

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Re: Option question for hedging portfolio
« Reply #14 on: February 11, 2021, 01:47:43 PM »
I'll add one strategy I haven't seen here yet. When options prices are too high for a collar (like now) I use a capped ratio spread that gives me the same protection at an acceptable cost. Glad to go into details if others haven't seen that used before. Right now I have a 100% hedge where I can lose at most 10% that expires in December 2021 that cost me about 1.5% to put on.

Yes please.

I'm increasingly interested in finding the most efficient way to obtain leveraged upside and/or limited downside. Too many friends putting money into Dogecoin, Tesla, and AMC.

BicycleB

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Re: Option question for hedging portfolio
« Reply #15 on: February 11, 2021, 02:09:26 PM »
Ptf/learn

maizefolk

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Re: Option question for hedging portfolio
« Reply #16 on: February 11, 2021, 04:11:42 PM »
I'd also be interested to hear about this.

MustacheAndaHalf

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Re: Option question for hedging portfolio
« Reply #17 on: February 12, 2021, 02:32:46 AM »
@yoda34 - Per the previous few posts, you have an audience for your strategy.

ChpBstrd

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Re: Option question for hedging portfolio
« Reply #18 on: February 12, 2021, 10:54:32 AM »
I'll add one strategy I haven't seen here yet. When options prices are too high for a collar (like now) I use a capped ratio spread that gives me the same protection at an acceptable cost. Glad to go into details if others haven't seen that used before. Right now I have a 100% hedge where I can lose at most 10% that expires in December 2021 that cost me about 1.5% to put on.
Did some research regarding the ratio spread strategy @yoda34 brought up. I didn't see any deals on SPY with 10% max downside and an initial cost 1.5% of the underlying. There are hundreds of possible combos, so maybe I'm not digging enough, and also the prices are constantly changing. It's a tradeoff between max downside and cost, but cost is pretty negligible anyway.

The 2to3 spread at 375/390 is a close candidate, with 11% max downside, 2.9% downside in the event of a big meltdown, and a cost at 3% of the underlying. However the breakeven point is over 10% above today's price, and that's a long haul for the next 10 months. See risk profile below...

In contrast a single long call at the 380 strike has a cost 9.7% of the underlying and a breakeven 6.8% above today's price. So in exchange for tying up more capital and not having a "big meltdown bonus", the single call has a lower breakeven.
« Last Edit: February 12, 2021, 10:56:17 AM by ChpBstrd »

MustacheAndaHalf

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Re: Option question for hedging portfolio
« Reply #19 on: February 12, 2021, 01:25:13 PM »
To me that looks like a bear call spread and buying a call option.  My calculation uses calls sold at the bid price (worst case) and calls bought at the ask price (worst case):

2 calls $375 sold for -$39.97 x 200 = -$7,994
(This option is $15 in the money, so you expect to owe $3,000 if nothing changes)
2 calls $390 bought for $30.70 x 200 = $6,140
(The selling minus buying leaves you with $1,854 cash)
Each $1 SPY drops means owing $200 less on the spread.  After $6 in drops, you owe $1800 on the spread and have $1854 in cash, so it's profitable after that.  If SPY has gains of 0% or more, you lose $1854 - $3000 = $1146

Now buy a $390 call for $3070, which is wasted if the SPY doesn't go up.  Any drop is now a loss, with a 0% drop being the worst case: $1854 cash - $3000 spread - $3070 call = $4216, which is 227% of the initial cash.  How far does SPY have to go up before this call pays for itself?  $30.70/sh on $390 or about 8%.  But it also has to pay for the spread of $30/sh (the call is 100 sh, but the spread is 200 sh).  This whole mix only breaks even after a gain of 15.6%.

The bull call spread profits on a drop, and the call profits on a gain.  I think that results in a contradictory position that loses money unless SPY gains 15.6%.

ChpBstrd

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Re: Option question for hedging portfolio
« Reply #20 on: February 12, 2021, 01:38:42 PM »
I think that results in a contradictory position that loses money unless SPY gains 15.6%.

In all fairness, I found some ratio spreads with a positive payout if SPY falls beyond a certain price, and if SPY rallies beyond a certain price. Kind of like a long straddle made cheaper by the sale of an option.

MustacheAndaHalf

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Re: Option question for hedging portfolio
« Reply #21 on: February 13, 2021, 09:35:05 AM »
Earlier, I actually tried to devise a ratio spread myself.  But it was flawed, and having seen the flaws, I'm not sure the concept works.

The ratio is really options in equal numbers, plus one or more additional options.  All of the ones that sell at a low price and buy at a higher price will have the contradiction I mentioned.  Flip it around (buy low price sell at higher price) and you wind up with a risk of unlimited losses: two spreads, and selling one call.

blue_green_sparks

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Re: Option question for hedging portfolio
« Reply #22 on: February 13, 2021, 10:47:14 AM »
Interesting approach in the attached link. You can have them do it for you at a cost of  0.79%. I have some shares and I think of them as bonds almost.
https://www.innovatoretfs.com/pdf/defined_outcome_mechanics.pdf

ChpBstrd

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Re: Option question for hedging portfolio
« Reply #23 on: February 16, 2021, 10:54:22 AM »
I think the ratio approach would get interesting if one kept the duration very long. While duration remains on the options, one's daily return does not follow the "at expiration" line. In the span of a few months, one gets a relatively smooth return function that accelerates toward the upside, sort of like the 1+Expiration line on the chart I shared. In the event of a fast correction, with plenty of duration remaining on one's options, all the options would have their value buttressed by IV, and you have 3 long, 2 short. Depending on the details, this could be a relatively smooth outcome. The downside of all this low portfolio volatility is that when the market goes up 1%, one's portfolio no doubt lags by whatever the net delta is. With lots of duration remaining, the return function resembles a protective put.

In a big, fast correction, with high volatility, one might get the attractive opportunity to reallocate, dropping the ratio spread and simply going long. This would be like riding the correction down at maybe 50% and riding the recovery at 100%. Of course, one can do this with a protective put too.

Interesting approach in the attached link. You can have them do it for you at a cost of  0.79%. I have some shares and I think of them as bonds almost.
https://www.innovatoretfs.com/pdf/defined_outcome_mechanics.pdf

I bet they are low-volatility, but given the explicit instructions about how to do this, I wonder how many investors are willing to pay them 0.79% to click the buttons on their behalf? What are the expected benefits of active management vs. DIY? I also wonder who at the patent office will think it's a reasonable idea to patent an option strategy. :)

NorCal

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Re: Option question for hedging portfolio
« Reply #24 on: February 19, 2021, 11:01:51 AM »
I'm not a fan of using long-term options in this case.  The time decay of option value is too big.

I strongly recommend reading the book "Asset Dedication".  It is an under-rated book that articulates a good draw-down strategy.

To oversimplify a bit, instead of thinking about your bonds as a percent of your portfolio, think of your bonds as your X number years of future spending. 

For example, if you're spending $40K/ year, buy $160K worth of bonds, with $40K maturing each year.  You can add another year to the back end of this when the market is high, and shorten the runway in years that the market is low.  This covers your sequence or returns risk, which allows you to take additional equity risk (if you want it) with the remainder of your portfolio.

I found the shift in thinking from "% of portfolio" to be very helpful.

MustacheAndaHalf

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Re: Option question for hedging portfolio
« Reply #25 on: February 19, 2021, 11:43:50 AM »
Interesting approach in the attached link. You can have them do it for you at a cost of  0.79%. I have some shares and I think of them as bonds almost.
https://www.innovatoretfs.com/pdf/defined_outcome_mechanics.pdf
They claim the following, which I dispute:
"The first layer involves buying and selling four options positions—two calls and two puts at pre-determined strikes to provide synthetic 1:1 exposure to the S&P 500"

They buy a call at 60% (of the S&P 500's price) and a put at 120%.  Those options work in opposite directions.  If the S&P 500 goes up $10, the call gains $10 and the put loses $10 (with some adj for time value).  That isn't exposure to the S&P 500, when you gain nothing when the S&P 500 goes up.

They also sell options, so even if the S&P 500 moves outside the 60% to 120% range, they gain nothing.  I think, to paraphrase Jim Kramer from decades ago when he was a stock analyst, they have found the perfect hedge: an investment that loses money in all scenarios.

yoda34

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Re: Option question for hedging portfolio
« Reply #26 on: February 25, 2021, 08:26:09 AM »
Sorry everyone - I was caught up in the Texas Armageddon. Just got power and water back and am working on property damage now. It was a pretty crazy and scary week.

So as others have pointed out ratio spreads are just buying/selling a number of calls/puts and buying/selling a number of call/puts at a ratio with a different strike price and same expiration.

Like any strategy there are trade offs and it's not a magic bullet, but I've found that it works for me when the VIX is too expensive for a simple put buy or a collar with an unacceptable restriction on the upside.

In this case, I sell an at the money SPX put or ES Future Option with either a 6 month or 12 month expiration depending on the current prices and what I'm willing to risk pay. I then buy 2 puts at a lower strike price. The difference between the short and long strikes vary for each trade and what I'm willing to settle for so it's a 1:2 ratio spread. You size the actual number based on the amount of the portfolio that you are hedging that is invested in the S&P. So for example a $1M portfolio in vested in VOO or something similar would be ~ 3 puts sold short and 6 puts bought at a lower strike price (just a rough guess based on current prices - didn't actually do the calculation for actual number required)

By selling the put at the money you get significant relief on buying the puts and can often get it for a much reduced amount when VIX is high.

When the market drops the first put you bought offsets the put you sold and the second put offsets the market position in the S&P.

Cons are that assuming you are again 100% hedged to the long S&P position you lose at twice the rate of the market between the strikes at expiration. I.E. if at expiration the market is down 5% and your long puts are 5% off the money then you lose 10%, however the 10% + cost of the position is the max that you can lose.

That's the theory, in practice however it often doesn't work like that because of theta and given that SPX options are 1. Cash settled and 2. European style so you don't have to worry about early exercise.

Let's say you put the position on Jan 1 and Jan 15 the market drops 5% below the short put. You will not be down 10% because of the time remaining on the option position - you'll often be positive money.

I know I'm late to this because of the weather and I've tried to cram this in - glad to discuss more or if anyone see's any issues with the trade that I haven't seen.

Also - looking at my actual position - the cost of the spread was ~2.5% in mid Jan. At the same time I did the position I also sold short several short term vertical spreads to help offset the cost even more - those spreads have since expired so on my tracking sheet it's showing me the cost of my hedge is currently at 1.5% - sorry that my initial number was off.

Edited to add performance graph. The below is the actual performance graph from IB showing how the combo performs. On the upside I only trail the S&P by the cost of the hedge.
« Last Edit: February 25, 2021, 08:54:30 AM by yoda34 »

MustacheAndaHalf

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Re: Option question for hedging portfolio
« Reply #27 on: February 25, 2021, 09:15:21 AM »
Feel free to correct me if I misunderstand ratio spreads.  Let me rearrange the description, so instead of selling one at the money put and buying two puts at 95% of the current price, I view it as two investments:

(1) Buying a $370 SPY put, selling a $390 SPY put.  This looks like a "bull put spread", where your losses are limited to the $20/sh spread.  You profit if the SPY stays above $390, letting you keep the full premium.

(2) Buying another $370 SPY put, which profits if SPY drops below $370.

I view it as one investment that profits only when the SPY doesn't drop, and another investment that only profits after the SPY drops.  Is there another way to view this, or do ratio spreads always have this tug of war in opposite directions?

ChpBstrd

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Re: Option question for hedging portfolio
« Reply #28 on: February 25, 2021, 09:38:38 AM »
Sorry everyone - I was caught up in the Texas Armageddon. Just got power and water back and am working on property damage now. It was a pretty crazy and scary week.

So as others have pointed out ratio spreads are just buying/selling a number of calls/puts and buying/selling a number of call/puts at a ratio with a different strike price and same expiration.

Like any strategy there are trade offs and it's not a magic bullet, but I've found that it works for me when the VIX is too expensive for a simple put buy or a collar with an unacceptable restriction on the upside.

In this case, I sell an at the money SPX put or ES Future Option with either a 6 month or 12 month expiration depending on the current prices and what I'm willing to risk pay. I then buy 2 puts at a lower strike price. The difference between the short and long strikes vary for each trade and what I'm willing to settle for so it's a 1:2 ratio spread. You size the actual number based on the amount of the portfolio that you are hedging that is invested in the S&P. So for example a $1M portfolio in vested in VOO or something similar would be ~ 3 puts sold short and 6 puts bought at a lower strike price (just a rough guess based on current prices - didn't actually do the calculation for actual number required)

By selling the put at the money you get significant relief on buying the puts and can often get it for a much reduced amount when VIX is high.

When the market drops the first put you bought offsets the put you sold and the second put offsets the market position in the S&P.

Cons are that assuming you are again 100% hedged to the long S&P position you lose at twice the rate of the market between the strikes at expiration. I.E. if at expiration the market is down 5% and your long puts are 5% off the money then you lose 10%, however the 10% + cost of the position is the max that you can lose.

That's the theory, in practice however it often doesn't work like that because of theta and given that SPX options are 1. Cash settled and 2. European style so you don't have to worry about early exercise.

Let's say you put the position on Jan 1 and Jan 15 the market drops 5% below the short put. You will not be down 10% because of the time remaining on the option position - you'll often be positive money.

I know I'm late to this because of the weather and I've tried to cram this in - glad to discuss more or if anyone see's any issues with the trade that I haven't seen.

Also - looking at my actual position - the cost of the spread was ~2.5% in mid Jan. At the same time I did the position I also sold short several short term vertical spreads to help offset the cost even more - those spreads have since expired so on my tracking sheet it's showing me the cost of my hedge is currently at 1.5% - sorry that my initial number was off.

Edited to add performance graph. The below is the actual performance graph from IB showing how the combo performs. On the upside I only trail the S&P by the cost of the hedge.

I guess you're looking at something like this risk profile. The essence of the strategy is to make the protective put cheaper by adding a bullish credit spread. The goal is to approximate a long stock position on the way up, but to have a safety net on the way down. Risk is added near the money in exchange for protection from a big correction event. So a big correction results in over-performance, a small correction results in under-performance, and if stocks go up the strategy roughly tracks the stock.

I presume during a correction you would see your options position appreciate, on net. In my example, the 389 put has a Vega of 1.52 and the two 350 puts each have a Vega of 1.34. So a one percent increase in the implied volatility of SPY would lead to a loss of $1.52 per share on the short put, and a gain of 2*1.34=$2.68 per share on the two long puts. That's not much, but it's on top of gains due to Delta (-0.51 for the short put, +0.68 for each of the two long puts). When the market drops 20% these combined effects might leave you with some interesting opportunities to drop the hedge for a profit and ride the recovery back up. I'm not genius enough to calculate the exact outcome.

Overall it's a position for someone who thinks the stock market will either keep going up or crash big, but not wallow in a small loss. It'll be a good play if this year looks like 1998 or 1999 or 2000. Plus, one could sell covered calls way OTM to probably eek out another 2% of return.
« Last Edit: February 25, 2021, 09:42:34 AM by ChpBstrd »

yoda34

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Re: Option question for hedging portfolio
« Reply #29 on: February 25, 2021, 10:02:34 AM »
@MustacheAndaHalf - that's a correct way of looking at the positions dis-aggregated. The important part here is how they work in concert - both with each other and a long market position

@ChpBstrd

That is exactly correct. When the market isn't losing much I'm not sure that I care if i trail by a few %, the scenario's i'm hedging for is protection vs fat tail crash while being able to capture the upside of the market. Looking at the market in totality the upside is the expectation - the crash is the black swan.

The performance graph you attached is exactly correct for the base position. The attachment I included doesn't look exactly the same because of the vertical spreads I've already sold which reduced the cost of the position. One thing to note that's the performance at expiration. If the market crash happens way before expiration you won't lose anything close to the max and may even make a positive return (including losses on the long market position).

That's the simple version - the more complicated version is because theta / delta gives you upside (as you've called out) - I sell short term spreads against the equity in the long market position to help offset the costs. Before I'm even half way through the option time, I'll have totally paid for the 2.5% cost. At that point, I can put another hedge on that extends my theta and have a long put position not capped by a short or long market position - this helps offset the risk of a short term wallow as you put it and makes the entire hedge gain quite alot in a crash situation. If you can manage your short term spreads without getting rolled by the stream roller you can roll the positions every 6 months or so and have pretty good results.

One more thing as an aside - with these (or any hedge) it is critically important to plan out in advance what your actions/steps/thresholds will be before a crash happens. I had a great collar play on in early 2020 (thanks to chpbstrd) that paid out beautifully in march. and while i didn't lose any money i didn't capitalize NEAR to the level I could have /should have if i had planned out in advance instead of just having an abstract idea of what I would do. I've since corrected that lack of foresight

Aside 2: Because my max losses are totally known i have zero issue with having 100% of net worth in market. Even with the occasional 10% loss you will way out perform long term any type of equity / bond mix and it makes the 100% equity ride much more manageable and less stressfull
« Last Edit: February 25, 2021, 11:11:13 AM by yoda34 »