Hedging question

[reactor]

Hi,

I need advice on hedging and welcome any thoughts on my question.

Suppose I've written a put option but the underlying now is at the strike.

Suppose the underlying is a futures.

If I decide to short the futures to hedge and the market carries on falling, at expiration, if I close out the futures and get exercised by the option buyer, am I correct that my only cost is the transaction cost to put on the futures hedge as I can offset my gain on the futures with the loss on the option?

What other costs have I not taken into account?

Thanks for your time!

 

[Rhody Trader]

You're right on the transaction costs - both for the option position and for the futures trade.

One quick thing, though. You would not close out the futures trade if you were going to have the put exercised. If you did, you'd be left with a long position.

 

[garethb]

If you hedge a short put with a short futures position what you have left is identical to a short call. Transaction costs aside, it is in effect the same as closing out the short put with whatever profit or loss you may at that point have and opening a short call at the same strike. You still have the benefit of the time decay but you have the exposure to a rise in the underlying. Think carefully if that is the overall position you wish to switch in to.

Regards,

Gareth

 

[reactor]

Thanks for the replies.

Rhody Trader - Surely I need to realize the profit of the futures to offset against my loss from the exercise of the option? At expiration I want everything square as they can be with the hedge.

garethb - I'm not considering changing position, just hedging at the strike with a futures. I'm going to accept a small loss if the futures rebounds back up again and close it out. The only problems I can forsee at the moment is that the futures might see-saw around the strike leading to a lot of transactions costs and stop losses of putting on the hedge.

If you have any opinions on the above, feel free to post a reply.

Thanks for your time!

 

[Rhody Trader]

Rhody Trader - Surely I need to realize the profit of the futures to offset against my loss from the exercise of the option? At expiration I want everything square as they can be with the hedge.

Absolutely you do, but here is what you said you were going to do in the futures:

Short the futures against the put
Close out the futures (buy) at option expiry
Have the put excercised.

The first two transactions are an offset: Short + Long = Zero net

The third part, though, is the problem. If the option is exercised, which I believe will happen automatically if it's in the money, the contract will be put to you, giving you a long position.

So this is what happens: Short + Long + Long = Net Long

What you should be doing is going Short then just using the option exercise to take you out of your short position: Short + Long = Zero net.

 

[reactor]

Apologies Rhody Trader, I should have mentioned the option, if exercised is cash settled, so I won't be assigned the futures contract! Once it is known what the expiration value of the futures is, I can close it out. Thanks for the prompter, it has made me aware that there maybe close out risk as well.

 

[garethb]

Reactor

When you next decide to change your position is imaterial. For the time you have the short put and the short futures position in place this is equivalent to holding a short call, If you are concerned that you will lose money if the market falls and you are holding a short put then you should be just as concerned about losing money if the market rises and you have a short call. To do otherwise is like following the old buy and hope mantra of a loss isn't a loss until you close the position.

If you ask yourself "If I had no position what position would I open?" and your answer is a short call, then your decision is correct i.e. hedge with a short future. If that is not the position you would open then don't hedge a short put with a short future. It's as simple as that.

Best of luck,


Gareth

 

[witjimnh]

This might help with Hedge Questions

The best way to hedge is the way some Fund Managers do with Market Neutral Investing. http://www.personalhedgefunds.com/ is a site that gives Calendar, Vertical and Diagonal Spreads and direction on entry points and exit points

 

[Danger Field]

Hedging as a trading activity on an existing position is pointless. You have an outright position which is either right or wrong. You are either staying in or getting out. This is the only decision you have at any and every point along the timeline of the trade's life.

Hedging only has benefit in the real world where folk are dealing in real produce and merchandise and are dealing with forward dates for delivery.

Hedging is insurance. Insurance is useful where you have a genuine basis for guarding against catastrophe (life, home, car etc.) and the probability of the catastrophe occurring is low and the premium correspondingly low.

In trading you have far more control in what you involve yourself and assessment of the relative probability of events. If you don't or it isn't then you aren't really trading - you're guessing.

 

[the blades]

Hedging as a trading activity on an existing position is pointless. You have an outright position which is either right or wrong. You are either staying in or getting out. This is the only decision you have at any and every point along the timeline of the trade's life.

Hedging only has benefit in the real world where folk are dealing in real produce and merchandise and are dealing with forward dates for delivery.

Hedging is insurance. Insurance is useful where you have a genuine basis for guarding against catastrophe (life, home, car etc.) and the probability of the catastrophe occurring is low and the premium correspondingly low.

In trading you have far more control in what you involve yourself and assessment of the relative probability of events. If you don't or it isn't then you aren't really trading - you're guessing.

Hello DF,

I hedge my equities portfolio with spreadbets on the FTSE100.The level of hedge is dependant on a systematic method, with the aim of fluctuating my exposure to UK equiteis.

For me, I can trade in and out of the FTSE very cheaply without incurring B/O spreads on equities.

Surely this is a valid form of hedging, no?

Cheers,
UTB

 

[Danger Field]

I guess I don't understand you.

What do you mean "fluctuating your exposure to UK equities"? You're opening trades on UK equities and then taking an opposite position via a spreadbet company on the same company?

I'm confused how this helps you avoid spread or how it can consistently turn a profit.

Keen to find out more though. I can completely reverse my views in less than the diameter of an atom if it makes sense to do so.

 

[the blades]

I guess I don't understand you.

What do you mean "fluctuating your exposure to UK equities"? You're opening trades on UK equities and then taking an opposite position via a spreadbet company on the same company?

I'm confused how this helps you avoid spread or how it can consistently turn a profit.

Keen to find out more though. I can completely reverse my views in less than the diameter of an atom if it makes sense to do so.

Eyup DF,

By hedging, I mean (for example), I own 10 UK stocks at £10K each (long positions). I'd take a £100K (equivalent) down bet on the FTSE100 to reduce my market exposure, leaving only stock specific exposure (I appreciate there's all sorts of other risks here but you get the gist....).

If I'm bullish on the short term market direction, I may want to increase my effective exposure, so I'd reduce my FTSE short to £50K. I could achieve the same thing by increasing my equity stakes, but as my opinion may change tomorrow, this would be expensive in terms of spread (say 0.5% per deal, compared to 1 pt spread on FTSE spreadbet).

Isn't this valid hedging, or sorts. Or is it as clear as mud

Cheers,
UTB

 

[Rhody Trader]

Eyup DF,

Buy hedging, I mean (for example), I own 10 UK stocks at £10K each (long positions). I'd take a £100K (equivalent) down bet on the FTSE100 to reduce my market exposure, leaving only stock specific exposure (I appreciate there's all sorts of other risks here but you get the gist....).

If I'm bullish on the short term market direction, I may want to increase my effective exposure, so I'd reduce my FTSE short to £50K. I could achieve the same thing by increasing my equity stakes, but as my opinion may change tomorrow, this would be expensive in terms of spread (say 0.5% per deal, compared to 1 pt spread on FTSE spreadbet).

Isn't this valid hedging, or sorts. Or is it as clear as mud

Cheers,
UTB

That's exactly what hedging is. You've got it spot on.

 

[charliechan]

Hi,

I need advice on hedging and welcome any thoughts on my question.

Suppose I've written a put option but the underlying now is at the strike.

Suppose the underlying is a futures.

If I decide to short the futures to hedge and the market carries on falling, at expiration, if I close out the futures and get exercised by the option buyer, am I correct that my only cost is the transaction cost to put on the futures hedge as I can offset my gain on the futures with the loss on the option?

What other costs have I not taken into account?

Thanks for your time!

its been a few years since i traded options, but....

you need to get a handle on the greeks, especially delta.

if you have an options position (1 contract) this doesnt mean you should hedge with 1 futures. you may need 2,3,4 etc depending on the options delta.

when we used to trade options on the floor, wed always aim to be delta neutral. that means we are not exposed to market direction, but trying to lock in premium from a volatility stand point.

you should get a copy of natenburg (option pricing and volatility theory - or something like that) if you havent done so already.

www.riskdoctor.com also has some neat stuff on options - but is probably a better read after natenburg.

options do my head in to be honest! id rather just trade outright futures! more money and less risk with options though if you can get your head round it!!!

 

[Profitaker]

To think of hedging as “insurance” is crude to say the least.

Technically any option spread is a hedge, where one position offsets another. Arbitrage is hedging, as is dispersion trading, buy-writes, gamma scalping (long straddles), Delta Neutral trading (short straddles), long Box, short Box, the list is almost endless.

When an option position moves, be it into profit or into loss, liquidation isn’t the only option (no pun intended), and certainly isn’t necessarily the best course of action.

 

[Rhody Trader]

Technically any option spread is a hedge, where one position offsets another. Arbitrage is hedging, as is dispersion trading, buy-writes, gamma scalping (long straddles), Delta Neutral trading (short straddles), long Box, short Box, the list is almost endless.

Maybe I'm getting picky here - and if so you can blame my university finance education for it - but to me hedging is defined by intent, not necessarily by action. If one is intentionally taking a position such as shorting index futures against a long stock position with the idea of protecting against a negative move in the overall market, that's a hedge. The trader is attempting to mitigate a specific risk.

Spread trades, arbitrage, and all that other stuff cannot necessarily be considered hedges. What are you hedging against? They are, instead, attempts to make very specific plays on the market. In some cases the implied protection of calling them hedge trades is virtually non-existant. A buy-write, for example, has an open-ended downside only slightly lessened by the premium received. Many spread trades do too. Arbitrage is about profiting off of small price discrepencies, essentially by taking offsetting positions. That's not a hedge because there's no market risk involved (or there shouldn't be anyway).

 

[Profitaker]

Rhody

If hedging is defined by intent rather than action, you're correct.

I find that notion strange. Take a buy-write for example - If I by stock today and immediately sell a Call you're saying that's not a hedge, but if I sell the call next week after the stock has risen (or fallen) it is a hedge ?

Personally, and I have no finance degree, I would have thought a hedge is defined as taking opposing position in the same asset, or underlying asset in the case of options. And this regardless of how effective the hedge actually is, buy-write for example.

I'm not very good at semantics.

 

[Rhody Trader]

I find that notion strange. Take a buy-write for example - If I by stock today and immediately sell a Call you're saying that's not a hedge, but if I sell the call next week after the stock has risen (or fallen) it is a hedge?

Personally, and I have no finance degree, I would have thought a hedge is defined as taking opposing position in the same asset, or underlying asset in the case of options. And this regardless of how effective the hedge actually is, buy-write for example.

A buy-write is an income strategy. It's intended to earn you a higher return than you would make just holding the stock. Is there a little protection against loss? Sure, a little. If you buy the stock at $100 and sell a 105 call for say $2, you'll get $2 worth of protection. That's not much when the market starts going south, though. You're right to say that a hedge need not be effective to still be a hedge, though, so you could call selling the option a weak hedge.

I don't think this is what you meant, but taking an opposing position in an asset is not a hedge - it's an offset. Why? Because you have eliminated all positional risk. For example, putting on simultaneous long and short positions in the same stock is an offset, not a hedge. How so? Because as long as you have both positions on you can neither make nor lose any money (aside from whatever profit or loss you fixed if the traders were made at different prices) regardless of where the market goes, and once you take one leg of the trade off, you're back to a direct exposure.

 

[reactor]

Thanks for all the contributions people!

Getting back on course, the reason why I originally started this thread was because I wanted to hedge an option that I have written once it is in the money and then take it off when it is not.

As I don't have a large portfolio of options that I'm hedging, it becomes more of a stop loss strategy. I was considering writing a strangle and then hedging when one of the legs is in the money, so in effect I am taking premium and this is where the profits will be coming from and the costs will only be those related to hedging and transactional costs. I'm hoping to get some constructive criticism on this method.

 

[Profitaker]

A buy-write is an income strategy.

Well, I maintain it's a hedge. Not the most effective hedge I grant you, but a hedge (by definition) all the same. How would you describe a collar ?

I had to remind myself that the only perfect hedge is a liquidation.

Reactor

Rather than hedging when "one of the legs is in the money", have a look at hedging at a pre-determined delta limit. Which is effectively what you're talking about anyway.... in a round-about way.