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ATM Hedging feature
Last Activity 7/28/2024 12:06 PM
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kmcintyre

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Subject : ATM Hedging feature
Posted : 2/16/2018 6:16 PM
Post #44095

Not sure if this should be in the OT or OV forum, but...

So I just ended Feb 18 option expiration. I've been hedging with 2:1 ratio put spreads on the QQQ, RUT, and SPY for the last year and a half.

A ratio put spread sells one ATM put and buys 2 (or more) slightly OTM puts. The ATM put helps pay for the OTM puts, which serve as a hedge for a portfolio.

I finally had a big drawdown. How did the hedging perform?

Not as I expected. My intent was to protect against a 3% drawdown. We had a 10% drawdown. But the put options that were placed 3% below the market only had a delta of approximately 50 when the market swooned 3%. As the market continued to drop the delta increased, but so did the bid/ask spreads. At the peak of the crash I was seeing $5 bid/ask spreads on the $2 wide ratio bear put spreads.

Yes, my portfolio would have been hedged had the market dropped to zero, but the reality was when I needed to unload the puts to collect my insurance benefit, the market didn't want to buy them. So they really didn't do me that much good. (The market really didn't want tell the puts either. Too much uncertainty. Hence the outrageous spreads.)

Lesson learned.

If I want to hedge my portfolio with puts, I need to buy puts that will have a delta > .90 at the point where I want insurance to kick in.

Using a ratio spread so try to reduce the cost of insurance seriously dampens the IV kicker of a selloff. But even on straight puts, the spreads can get so wide, IV doesn't matter that much. The market makers are going to screw you if you want to buy or sell.

I have heard of another way to hedge using futures and options. The idea is to put on a delta neutral trade with put options and long e-minis. If the market rises, the puts lose delta while the e-mini holds a delta of 500. So you make money. If the market drops, the puts gain delta while the e-minis hold their delta of 500, so you make money. Sounds too good to me true. (My guess is that the costs involved might be prohibitive...)

Just thought I'd share. If anyone has a tried and true hedging method, please let me know!

Cheers!

Keith


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Jim Dean

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Subject : RE: ATM Hedging feature
Posted : 2/16/2018 7:37 PM
Post #44096 - In reply to #44095

Thanks Keith for the words of caution. I follow what you are saying but frankly don’t have enough experience to evaluate whether it has a bearing on the new feature addition that N plans for ATM. I hope that someone from N staff will address these considerations, and if they might be valid in some cases, will explain how the proposed Put-protection will circumvent them.
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John J

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Subject : RE: ATM Hedging feature
Posted : 2/17/2018 3:36 PM
Post #44098 - In reply to #44095

It doesn't make much sense to put on delta neutral trades with put options and long e-minis in conjunction with long stock positions. I have requested for quite some time now that N develops a delta neutral trading module. Basically, with delta neutral strategies you're only interested in movement in the underlying as direction is irrelevant. Once the position has moved a certain percentage or $ value, a decision needs to be made whether to close the trade or re-adjust the position in order to stay delta neutral. I realize that N may be hesitant to develop such a module as it wouldn't be based on entry signals (N's bread and butter). However, signals could definitely be used to determine whether to close the trade or re-adjust (as mentioned above).

Here are my two cents regarding the ongoing development of the ATM system, specifically in conjunction with option trade management. As most members in here are aware of, option strategies per se have not yet been implemented, only option tradeplans. A signal produced by a strategy is nothing but a binary determination (the signal is either 100% bullish/bearish or nothing at all). With options on the other hand, the option spread you pick depends on HOW bullish/bearish/neutral you happen to be, and a signal doesn't provide such info (for instance it doesn't make any sense at all to have signals trigger neutral option trades, only whenever a certain condition occurs).

What's the workaround? Let's say I'm employing a single strategy for signal generation. The market state should obviously govern what option tradeplan to use, which means I have to make several versions of the same strategy (i.e for a very bullish market state I may want to use long calls in the tradeplan and for a less bullish one I may want to use a vertical call spread instead). There is definitely room for improvement in this area...

[Edited by John J on 2/17/2018 3:52 PM]

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LSJ

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Subject : RE: ATM Hedging feature
Posted : 2/18/2018 8:22 AM
Post #44099 - In reply to #44095

I'm employing a hedged strategy trading stock pairs that worked very well during the swoon.

I believe the key is using highly co-integrated pairs and would like to see N add that calculation in Pairtrader. The results of my backtests using co-integration greater than .9 can show a variation in correlation of as much as -30% to 90%+ over a year. I am not fully conversant with the in-depth math but looking at results I conclude that co-integration is a powerful determinant and more reliable than correlation alone.

I have looked at trading hedged stock pairs using options but liquidity and IV often do not co-operate so I stick with straight long/short stocks.
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kmcintyre

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Subject : RE: ATM Hedging feature
Posted : 2/18/2018 12:22 PM
Post #44101 - In reply to #44099

LSJ - I'd love to learn more. How about a new thread dedicated to the nuances of pair trading? You know things I don't! :-)

As for N's future implementation of a simple long put strategy for protecting against a meltdown, I've been giving it a bit more thought (
'cuz I need to improve my own hedging strategy...)

I think the gamma curve is key to picking the right put option to buy for protection. The gamma curve is an 'S' curve. The change in gamma happens quickest in the middle of the curve. As expiration approaches the curve becomes a step function - 0 or 1 - in the money or out. Delta of 0 or 1...

Also of significance is the theta decay curve. The cost of long options is most expensive near expiration, when the gamma curve is steepest. Holding long options with a large DTE (days to expiration) costs less per day, but their delta (and hence value) isn't going to move much in a market crash since time for the market to recover is built into the option. Weekly options cost the most per day to hold (highest theta) but have extreme gamma swings that move delta from 0 to 100 with a small move in the underlyings price.

I want catastrophic insurance. I want to buy cheap options that pay off immediately in a flash crash. So for me, shorter term options (DTE < 15) make sense. I want to buy a strike that is very close to the price I want my insurance to kick in. I expect that I'll have 0 benefit if the underlying (QQQ, RUT, SPY) doesn't fall below my strike. I expect that I'll recieve a nice payout (insurance benefit check) if the market drops below my strike. The closer to option expiration, the higher the delta, and the closer to 1:1 payout I'll get.

I have been buying longer term (DTE > 30) ratio spreads to keep the cost of insurance lower. That approach would pay off if I held them to expiration and the market ended up significantly below my long put strike. (Mostly because the long term options become short term options eventually, so they eventually get to a high delta and start approaching 1:1 downside coverage...)

So how much are low DTE OTM puts going to cost me? Is the cost of insurance worth it? That will take more analysis. But generally, the edge is always in favor of the house, the option sellers. Options are priced such that over the long haul option writers have the edge.

But that doesn't mean I don't want to buy insurance, be it home, auto, health, death, or portfolio.)

Happy Presidents Day!

Keith

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Jim Dean

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Subject : RE: ATM Hedging feature
Posted : 2/18/2018 1:14 PM
Post #44102 - In reply to #44101

Thanks Keith. I understood about 95% of what you said, and it makes a lot of sense. Ed's presentation seemed to focus on contracts that had the highest activity, rather than looking at any greeks. The only thing that I recall he said about time is that the rebalancing is done once a month ... that seemed a bit extended to me ... my gut says that in worrisome situations I'd want to see rebalancing weekly.

AND, gosh, let's not forget the tried and true methods ... *use tighter stops*, and *diversify*. So far I've not seen provision in ATM for diversification via correlation of Groups or Sectors etc, which I've always been a proponent of. But ... doing that "easily" for the user would require separate simultaneous industry-specific focus lists, much like OVest has multiple portfolios in play at once. I sure do hope that N starts thinking about market state in those terms, because there are ancilliary benefits re diversification.

[Edited by Jim Dean on 2/18/2018 1:14 PM]

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Vinay

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Subject : RE: ATM Hedging feature
Posted : 2/19/2018 8:47 AM
Post #44107 - In reply to #44095

If we try to hedge our portfolio buying Put options as ATM seeks to implement, it is bound to affect the returns adversely, because we need to keep on buying protection every week/month which may become useful after several months but we will need to pay premium every week/month. In the long run the option writer is always the winner. So for me this is not a viable option.

As far as Jim's suggestion of using *use tighter stops* and *diversify* is concerned I have a different view (sorry Jim). If we use tighter stops they may or may not protect us from disaster when the "doomsday" comes because there is high probability that our stop orders will not get filled at our stop levels. Even if that were to happen the tight stops will kill our portfolio by thousand cuts by getting us out frequently at the wrong time when market conditions are normal.

Regarding diversification we all know that it works when the market behaves normally. When the "Black Swan" event occurs or when we are hit by the "Fat Tail" the equity diversification becomes useless because under severe stress the correlation between all shares quickly approaches one and they all fall like nine pins at the same time. So diversification fails us when we need it the most.

After dabbling into stocks for more than 3 decades I have come to believe that there there is no surefire way of downside protection in stock markets. The only way to survive in this market is NOT to use margins and never borrow money to play this game. If you stick to this simple principle I am sure you will always survive any Flash Crash or another 2008 to fight the battle and recoup your losses because the recovery after the fall is also always commensurate with the degree of previous fall.




[Edited by Vinay on 2/19/2018 8:59 AM]

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Jim Dean

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Subject : RE: ATM Hedging feature
Posted : 2/19/2018 8:59 AM
Post #44108 - In reply to #44107

Hi, Vinay

First, re repeatedly buying Puts ... Ed dealt with that cost in his webinar ... what he didn't spend a lot of time discussing was that every week/month when the put was rolled over, some of the old one's cost (unspecified) would be recovered when it was sold. Yes, there will be a net cost ... it is insurance for a price ... but Ed made that point. However, Keith's comments lead me to believe that the benefit from exercising the Put in the event of a crash will be less than Ed implied ... but he never actually quantified it since the sale of the Put was never tabulated. Hopefully that will come as N continues work on this.

Re the classic trailing stop and diversification methods ... I was *not* proposing them as ideal nor completely effective solutions! Rather, I was trying to point out that using them *wisely* (and that's an important qualifier) can sometimes *ameliorate some* of the crash impact. Why?
a. really big crashes often last more than one "bar" ... a tight SM would at least end the trade before another bar makes it worse, in those cases.
b. during many med-large crashes, there are usually *some* symbols that *don't* crash ... esp if they aren't a part of major indexes. Admittedly it's tricky to predict which symbols might benefit from this disconnect ahead of time ... BUT if there's a lot of *intelligent* diversification in the portfolio, then there's a reasonable chance that *some* of the symbols might make it ok.

So, to repeat ... tight SM orders and wise diversification can HELP in a crash ... but they can't completely obviate it.
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Mel

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Subject : RE: ATM Hedging feature
Posted : 2/19/2018 3:40 PM
Post #44112 - In reply to #44108

Larry, what tool do you use to calculate cointegration?

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LSJ

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Subject : RE: ATM Hedging feature
Posted : 6/9/2018 11:10 AM
Post #44784 - In reply to #44112

Mel,
Sorry I'm so late responding. This thread slipped out of my focus.

I use a program called Pairtradefinder. I paid $100 for it a few years ago and it has since been bought buy a U.K. company that has more agressively promoted it and has added features and functionality. They occasionally put out specials on it and currently it costs $30 to $50/month depending on the special and usually for a 3-month or annual subscription but they do offer a trial: http://www.pairtradefinder.com/

The biggest job the user has is building pairs for correlated lists. I use Omniscan Industry Groups to populate lists and then copy the symbols into my Pairtradefinder backtester.

Here's a couple screenshots:





[Edited by LSJ on 6/9/2018 11:44 AM]

Attached file : PTF 1.jpg (146KB - 536 downloads)
Attached file : PTF _002.jpg (209KB - 513 downloads)

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Vinay

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Subject : RE: ATM Hedging feature
Posted : 6/9/2018 12:34 PM
Post #44785 - In reply to #44095

I think this research article by Roni Israelov regarding Protective Puts is interesting and an eye opener:

"Pathetic Protection: The Elusive Benefits of Protective Puts"

In gist of this article is that conventional wisdom is that put options are effective drawdown protection tools. Unfortunately, in the typical use case, put options are quite ineffective at reducing drawdowns versus the simple alternative of statically reducing exposure to the underlying asset. Unless your option purchases and their maturities are timed just right around equity drawdowns, they may offer little downside protection. In fact, protective puts could make things worse by increasing rather than decreasing drawdowns and volatility per unit of expected return.

If interested you can download the entire from the following link:

https://www.aqr.com/-/media/AQR/Documents/Insights/Alternative-Thinking/AQR_Pathetic-Protection-The-Elusive-Benefits-of-Protective-Puts.pdf

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kmcintyre

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Subject : RE: ATM Hedging feature
Posted : 6/9/2018 1:22 PM
Post #44787 - In reply to #44095

That has been my empirical observation.

A protective put is an insurance policy. But the questions are -
1) how do you file a claim
2) when do you file a claim

The how could be as simple as "sell your put". But then you have no protection. So maybe you roll the put. Out, down, down and out? Or maybe sell a put against the ITM insurance policy? a calendar or a credit spread?


The options are myriad. pardon the pun...

This I know - when you want to cash in on the insurance, when there's blood in the streets, the spreads are TERRIBLE.

Which gets to the when question. Protective puts look great as unrealized gains as the market tanks. If you hold them until expiration you risk a bounce back (great for the rest of the portfolio) which cuts deep into the unrealized profits. You end up paying for protection you never used, and really didn't need, assuming patience to wait for a rebound in the market.


Exercising the put takes a lot of cash (the size of the portfolio being protected by the puts!) and leaves 2x the original portfolio exposed to further downside movement. Hummm...

And as I mentioned, trying to time the bottom and selling the puts is difficult because IV is typically very high, causing bid/ask spreads to swell. The puts are a hot potatoe...

But for some, having a smoother unrealized equity curve is worth the price of admission.

Protective puts - no free lunch. IMO

Cheers


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