Best way to hedge?

F&O
1

I’m weighing the pros and cons of using weekly vs. same-expiry hedges. I only want to hedge against tail risk and not regular market movements.

For example, if I’ve sold June 22,000 put option and I want to hedge 500 points out, should I buy 21,000 put option expiring in June and consider it a part of my June expiry strategy, or should I just buy weeklies at the same strike (and possibly sell some far OTM options to fund them)?

I’m leaning more towards weeklies because that way I pay a lot less for hedges.

What are your thoughts and are there any loopholes to consider if I go with weeklies?

2

Probably you should develop a systematic option strategy which provides you with a hedge by default (by its inherent nature).

Both Option buying and Option selling systems can be developed on this. A backtested system would also mean that you know it works and has a clear edge.

Basically we all know that a hedge entails cost. Developing a system / strategy would mean that you are able to turn this cost into a revenue stream.

1 Like
3

Probably you should develop a systematic option strategy which provides you with a hedge by default (by its inherent nature).

That sounds nice. Can you expand on how this would work?

Currently, I’m transitioning from selling naked options (I’ve always done it this way) to looking at hedges a bit more strategically.

I’m OK not turning them into a revenue stream as long as the costs are low and I’m protected against tail risks, but your proposal sounds interesting.

4

Ultimately it’s you who has to develop this strategy. You can filter through multiple strategies to come up with the one which fits this criteria + is aligned with your own psychology and personality type.

You can imagine that the equity curve of such a strategy (generally) should be sideways / going down when market is sideways / going up while the edge will play out in bear market. Though it totally depends upon your strategy and the rules of execution you set.

If it’s an option selling strategy, you can pledge your stocks to generate margin and execute it. It will be like every rupee working at two different places instead of one.

5

What you’re explaining isn’t my forte, but your analogy is definitely interesting.

For now, I’m only trying to hedge my short options positions in the most cost-effective way.

6

Weeklies decay faster, and after expiry you would keep buying Weekly hedges or what?

7

Hedging always involves a cost, and a “cost-effective hedge” that is too cheap may not actually be a Hedge at all.

3 Likes
8

Loopholes I dont think so there can be any, However it depends on how often you would want to trade.

Weekly options maybe cheap but there can be liquidity issue and volatility can be effected.

If you can stay strong with monthly it can be systematic.

9

Yes.

10

How exactly? If I go short 22k put and long 21k put, my max loss is 1,000 points as long as I hold that put (whether the long leg is long-dated or weekly is not relevant, right?). Am I missing something?

11

I intend to use them as a hedge so I have no intention of profiting from them (or even exiting from them until expiry) so liquidity and volatility aren’t too big a problem for me.

Monthly is usually quite expensive to use a hedge.

Even when I’m hedging with weeklies, most of the times, I go short calls (if that aligns with my view for the week) to reduce the cost of hedging further.

12

Yes. A lot.

You are not quantifying the 1000 points in actual numbers in terms of margin and loss. Imagine there is exactly a 1000 point slow and grinding drop till expiry.

Max Loss of 1000 Pts = Rs -75000. (LotSize: 75)
1 Bull Put Spread Margin = Rs 100000 (Approx).

This implies, if you were all in with portfolio of 1 lakh, you have lost 75% of your portfolio with the hedge leg giving 0 profit even after 4.5% drop in NIFTY. This means you are out of the game. In fact you will get a margin call way before this point. It was a cheap hedge that did reduce the margin (approx. 50k) but provided no protection whatsoever.

So it is a poor trade to begin with. Hope you see it.

As far as the weekly / monthly is concerned, if you add the rollover cost, cost of carry, occasional IV spikes, brokerage, taxes and slippages - premium will work out the same. But weekly will have operational risk every time you break the hedge and roll over.

13

I do know that it will cost me 75k :slight_smile:

But it wouldn’t be 75% of my margin because I don’t do spreads.

Also, the point of hedging here is to protect against black swan events ONLY.

If there was a theoretical surety of no black swan events, I wouldn’t hedge at all.

I don’t buy options to get margin benefit or minimize losses during regular trading.

Slippage, IV spikes, brokerage – none of these are a problem for me.

All I want to know if is the pros/cons or weeklies vs monthlies for hedging AGAINST A BLACK SWAN event.

I know it’s an unconventional approach, but it sounds theoretically sound to me. I need someone to pinpoint potential loopholes here :slight_smile:

14

Your strategy is called Bull Put Spread.

Also, just out of curiosity, what percentage portfolio hit do you consider as black swan. It doesn’t matter what is happening in the market. What matters is the effect of the event on your portfolio.

Anyhow, I don’t think we are on the same page for me to comment further … But hey - Best of luck.

1 Like
15

Those are just two legs of the overall trade. I only mentioned those two to keep things simple :slight_smile:

Loss during a black swan is part of my overall margin management structure, which is outside the scope here and a bit tedious to explain. But I’m aiming to limit the hit to 30% of the total margin.

16

@Jason_Castelino maybe you have some inputs here? I need someone who understands what I’m trying to do here.

17

I go without hedge most of the time. This is also mainly because I sell cash secured puts.

1 Like
18

@Meher_Smaran know anyone who might be able to weigh in on this?