Posted by Frugal on 30th April 2007
Following what Hussman has done, I was going to implement the exact same strategy for my own portfolio. Essentially, he was long in stocks, and short in puts and also short by writing deep-in-the-money calls.
Just to illustrate what is going on, I took a snapshot of XHB options (XHB closed at 35.04 on last Friday) (Click to open the Excel file):
Assuming that if you hedge your stocks by selling calls at strike price of 33, and buying puts at strike price of 35, you will actually end up with (2.5 – 0.8) = 1.7 per share of XHB or $170 per 1 contract of call sold and 1 contract of put bought (using the last price instead of taking the worst case with bid/ask). Sounds like a great deal, eh? Hedge while earning money?
Of course, there is never free money in the stock market or anywhere. If XHB closed at $35 on May 19th (when May options expire), your sold call will have a value of $2, and you will have a paper loss of ($1.7 – $2) = -$0.30 per share of XHB. If XHB closed at $37, your sold call will have a value of $4, and you will have a loss of ($1.7 – $4) = -$2.3. Only when XHB falls as you expects, for example falling to $33, you will have a paper gain of $1.7 + $2 from puts = $3.7.
Notice that because your hedge is done with both calls and puts, per share -wise, the delta increase/decrease is roughly $2 per share for every $1 price movement within the band of strike price between $33 for call and $35 for put (gain/loss at $33 is $3.7, and gain/loss at $35 is -$0.30, total of $4 for $2 price movement). Beyond the price band, either call or put will expire worthlessly. So the additional price delta beyond the band will be $1 instead of $2.
Because of the doubling of the price movement to gain/loss, your risk/opportunity is really TWICE per share of position. In order to compensate for this factor, I STRONGLY advise anyone to reduce the option trading size by HALF. Supposed you hold 200 share of XHB, and want to hedge it, you should sell 1 contract of call and buy 1 contract of put.
In what aspects is this strategy better than other bearish option trading strategies such as simply selling calls or simply buying puts or creating a bearish spread? In my opinion, this strategy is better for the following reasons:
1. Comparing to buying puts alone, you are not penalized by the time premium of $0.80 so much. Get partially compensated from writing calls. However because your calls are deeper in-the-money, the time premium will be increasingly less as the calls go deeper in-the-money. It is a trade-off that you must make between how low you think the market may go to hedge your positions.
2. Comparing to selling (covered) deep in-the-money calls alone, you have a 50% downside hedge from the puts (if you use half-sized option positions). This is an additional downside protection when the market falls lower than you expects from your sold deep in-the-money calls.
3. Comparing to bearish call spread (at 33 and 35), you will pocket initial premium difference of ($2.5 – $0.9) = $1.6 or $3.2 per 2 contracts executed (this is also your maximum gain). Your maximum loss is $1.6 – $2 = -$0.4 or -$0.8 per 2 contracts executed. In comparison to $3.7 and -$0.3 from 1 call and 1 put done by Hussman, not only your gain/loss is lower, but also you don’t get the additional 50% downside protection.
4. Comparing to bearish put spread, your maximum loss is the initial premium deficit of $0.2 (I’m using the ask at 33) – $0.8 = -$0.6, or -$1.2 per 2 contracts. Your maximum profit is -$0.6 + 2 = $1.4 or $2.8 per 2 contracts. Again, you don’t have 50% additional downside protection from this case.
I don’t know whether it’s always true that 1 sold call + 1 put will always give you a better gain/loss at the two strike prices, but comparing the bearish call/put spread strategies, it always depends on how bullish the market sentiment is. If the time premium is bigger in calls than puts, then usually it’s better to do a bearish put spread.
In any case, the additional 50% downside protection from the put that you have really comes at the expense of additional 50% potential loss for your hedges when the market goes higher than you expect. Nothing is really “free”.
You don’t necessarily do 50:50 call/put split. You can do any percentile splits if you like, depending on your confidence level on the two strike price.
Also note in this not-so-good example, you are actually much better off if you simply sell 200 shares of your current XHB shares per every 2 option contract executed. If XHB falls from $35 to $33, your loss is really total of $4, bigger than any of the maximum profit potential listed above.
The bottom line is that if you cannot capture the time premium for yourself, you might as well sell your shares instead of hedging your shares. The noted exception is that you’re holding your shares for tax reason. Another noted exception is obviously that your hedge is a cross-hedge (like Hussman’s) where you believe that your holding stocks will do better than the stocks that you are shorting.
However the most important thing to take away is that hedging is equivalent to selling. If you hedge/sell, and you don’t sell at the high price, your performance will definitely suffer. As long as between the time you hedge/sell, and the time you close your hedge/short, you net with a profit, then your performance can be enhanced through the hedging.
Hedging/Selling smart is really the most difficult thing.
For more option strategy, NUMA has very good graphical illustration of most option strategies. But I do advise anyone who trade options to first paper-trade. Otherwise, when you buy/sell longer term call/put, and the market moves to your advantage, you will be saying to yourself, “what the heck, how come my options don’t go up/down as much?” This price action cannot be shown in the option diagrams unfortunately. More on this later….
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