Better to hedge with Leaps or front month options?

Posted by made to trade on December 04, 2011 (01:54PM)


Hey,

So I will be holding/bullish on something for as far as I can project.  Just to verify, it would be more cost effective to buy a put that has an expiration that is far out into the future, than to buy puts every month?  Assuming the same strike price that is.  Although if I do buy puts every month, I could adjust the strike price monthly as the underlying moves.

I'm not looking to make money on this options position, only to hedge in case of a black swan event happens.  Therefore I am fine if the option expires worthless and I lose the premium.  Granted, I would not mind it if I sell my option position for a profit if the underlying asset did move towards the strike price.

So Leaps > near month options solely for hedging purposes?  Or perhaps a put with an expiration that is between the two?

Thanks!

Posted by NYSEguy on December 04, 2011 (08:03PM)


made to trade said: So I will be holding/bullish on something for as far as I can project.  Just to verify, it would be more cost effective to buy a put that has an expiration that is far out into the future, than to buy puts every month?  Assuming the same strike price that is.  Although if I do buy puts every month, I could adjust the strike price monthly as the underlying moves.

I'm not looking to make money on this options position, only to hedge in case of a black swan event happens.  Therefore I am fine if the option expires worthless and I lose the premium.  Granted, I would not mind it if I sell my option position for a profit if the underlying asset did move towards the strike price.


I think the determining factor is the time frame of your investment.  If you're planning to hold the underlying for, say, ten years, then hedging with a put may not make sense because you'll likely be able to tolerate short-term price drops.  If you envision a shorter time period for reaching your price target then your expectations can help you choose a strike price and expiration month.  Also, you'll have some idea of how much option premium you're willing to pay.

In the end, as always, it's risk versus reward.

Posted by doougle on December 05, 2011 (08:10AM)

The Implied Volatility is on the high side right now.  That means you'll be paying more for that hedge.  If you buy the LEAP, you'll lock in that higher rate and your underlying stock might be much higher at expiration, meaning your hedge is less meaningful.  So, I'd say buy it a month or two at a time.  With any luck, you'll be locking in a higher profit as you go.

To offset some of that higher cost, you might consider doing a collar.  That's where you buy the put and sell a call to make it cheaper.  But make sure you don't get too greedy on the call side.  People try to create zero cost collars and end up giving up their stock before they're ready.

Posted by OldFart on December 05, 2011 (11:24AM)

MTT - just a different perspective but I usually do not get "married" to a position. If it is down, let's say > X%, out. Now hedging for black swans is different, at least in my mind. You need to hedge everything in your portfolio. Some gurus suggest to beta-weight the portfolio and hedge with SPY/SPX puts. Other gurus suggest that the market goes up and the fixed puts may move too much OTM to be an effective hedge, they prefer hedging with VIX calls which are much more dynamic or one of the VIX ETNs

Posted by TK All-Star on December 05, 2011 (03:16PM)

MT,

When buying puts for protection, the first truth is that it is an expensive proposition. Much of the time, you will lose more on the puts than you gain from an increase in the stock price. Thus, before embarking on this play, be certain that you truly want to own stock and puts.

Just a note: In case you are unaware, owning stock plus a specific put gives you a position that is equivalent to owning the call option that has the same strike and expiration as the put. Thus, you must answer this question: How do you feel about owning calls instead of stock? When looking at the plan this way, some investors shy away from the put + stock approach.

Your plan to use monthly options is very costly. However, it does allow frequent changing of strike prices . That is something of great value. The problem is determining whether that value is worth the cost of owning one- or two-month options.

The attraction of owning LEAPS puts is that they decay very slowly. However, we must remember that you own this stock because you are bullish. If it rises by 20%, your put option is going to be significantly out of the money, and thus, offer little protection. Yes, you can sell it and buy another put with a higher strike. There is nothing inherently wrong with that plan, but when you buy that long-term put, you get more than downside protection. You have an investment in volatility. By that I mean these puts are vega-rich. [Vega is the ‘Greek’ measures an option’s sensitivity to a change in the implied volatility. It’s one thing to invest in the protective powers of a put, but there is no reason for you to pay for unneeded vega. If you believe volatility will be increasing, then LEAPS puts may be right for you.

Not trying to discourage you. Just want to be sure you know what is involved with your plans.


Mark Wolfinger

Posted by made to trade on December 05, 2011 (11:20PM)

Thanks for all the responses.  I really appreciate it.

NYSEGuy: I've thought about my time frame and have been siding towards LEAPs.  I am fine with short term swings, but I am just afraid of the unexpected, as my portfolio isn't that diversified.

Doougle: Good point.  I did not think of that and thanks for bringing it up.  I've been selling a lot of options to take advantage of the high premiums, but the concept of high premiums completely slipped my mind when I started thinking about buying them. 

Would locking up a high premium through buying a LEAP be more expensive than buying numerous short term options?  I for some reason have thought that if you divide (time premium) by (time till expiration) for same strike options of different times, the longer the time till expiration, the less you are relatively paying for the time premium.  I am not sure if this is true or not though.

OldFart: I just recently started trading and have been lucky enough to not be wiped out yet, as I haven't really been hedging.  I know I'm playing with fire by not hedging so that's why I've decided to think about ways to hedge my portfolio now.  My luck will run out one day and it's better to be safe than sorry.

As for 'marrying' the position...I guess I should clarify what I am trying to do.  I'm not exactly buying and holding and selling 30 years later at a profit.  While that would be nice, that's not my main goal.  To come clean, I am very bullish on oil, which is the asset I have in mind when writing this thread.  I see potential upside (granted it could be awhile until its realized), but what I see more is value that won't be lost.  Even if oil prices drop, oil is still worth something in the end, unlike stock.  I also feel there is more support for oil in case of a price decline, especially with OPEC and its production rules.

I've been holding oil and taking advantage of the recent volatility and just the fact that commodities are riskier by selling puts and covered calls.  I am trading in a cash account so I kind of have to hold oil in order to sell covered calls.  Since oil is part investment part 'tool' I guess, that allows me to trade options, my primary objective is not to buy low and sell high.  It's to maintain an asset that won't lose too much value and has upside and trade around it.  If my covered call gets exercised, depending on the short term outlook, I might just buy oil again or start selling more puts.  (I've also considered rolling over my position if my covered call is in the money, i.e. buying back the call on expiration...don't know if that's smart.  I would receive a smaller profit from closing out the position, but I'd get to keep my oil).  If my puts get assigned, I'm fine with it because I'm bullish on oil in the long run.

But if a black swan happens, well, I'm screwed.  That's why I need to hedge.

TK All-Star:  Buying a put is expensive.  I've been looking at some prices and it could take a chunk out of my profits.  As a result, I am open to other ways of hedging, including making investments in inverted oil funds or perhaps even an asset that may be moderately negatively correlated like the VIX.

I do realize I'll probably lose more on the put than I gain from a rise in the underlying.  But my strategy is to increase my profits with covered calls and shorting puts.  Perhaps if I do enough of those short term trades, I can eventually pay off the LEAPs and start making profits?

I'm also open to any criticisms of my trading plan.  It has worked well so far.  Compared to my 401K which has made like 0.2% in 4 months (and that's with about 80% in bonds, which is the complete opposite of what I should be doing for my age) and I've only been trading for 3 months, active management has so far beat a passive management style.  Now, I just hope I can stay consistent.

Whew long post!

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