Hedging with Options? Reducing risk on entry.

Apr 13, 2004
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Sydney
#1
Hi there,
I am trading share Futures and CFD's in Australin market, and wish to reduce my downside exposure in a way that avoids having to place a tight stop.
I have been monitoring two large cap stocks, BHP and CBA on ASX.
what I have noticed is that when a stock is down, such as BHP at the moment after a large correction, puts around at the money tend to be over-valued. ie they are > than options valuation. This is particularly true for out of money puts. Also the further out you go from the strike price when buying puts, the less the delta so that the protection is less. SO saving money by buying cheap puts after you go long,say on the underlying stock, CFD or futures,
doesn't really save you money as it costs more when underlying price moves against you.
But on the whole I found that puts at or in the money protect you better, by more than half the potential loss. For example, if BHP moved down 50 cents, I would normally only lose 25c or less by the time I purchased the put option back. If it gapped down $1.00, I would only lose 50 c or less....
This is very useful, as it avoids any nasty little surprises should there be adverse, volotile price movements and I can lock in a predetermined amount of loss in line with my risk management strategies eg no loss > than 1 % capital.

My question is, this being all theory so far, is how has this worked for others? Is the practical different from how I am speculating in regard to hedging?

When the stock goes against my position, such as if I sold CBA on 4th MAY, and bought at the money June Calls....I found that the stock rallied by Friday 6th MAY by 0.62 c, and the option
gained only 22 c, so the net loss was 42 c. that's ok, its still within my 1% allowable loss.

However, BHP moved in my favour 26 c after buying on 4th MAY, however, my at the money put options lost more than expected. 18c ..primarily because when I bought them they were slightly overvalued, and volatility measures such as vega have dropped.... ( the psychology being that panic is diminishing, hence volatility , due to a slower coutertrend rally )

How do I buy the put options at a reasonable price?

I thought I might try further in the money options, which only improve the hedge, but actually reduce the profit side when the stock runs my way.....
Do I get out of the hedge at a certain stage in the stocks rally, and set a stop at my buy price?
I thought if the stock rallies say $1.00 in profit, I could cut the losses of the puts options,
and place a stop loss at my buy price....
But if Long futures, thats no protection against a crach is it???

SO you have to leave the put alone, and accept losing that premium every trade, and gain sufficient profit to make it all worthwhile....for instance, you 're happy spending 0.5% on protection options, but you must gain at least 3 times that and make 1.5% or greater your overall capital per trade. The you must win at least 33% of time ot break even.

Another tactic was to use CFD's, and after the stock rallies, liquidate your options for small loss and place a garanteed stop loss somewhere such as at +0.25% profit. Thereby reducing your trade entry risk to negligible levels.

SO, regardless of strategy, my plan is to try this and protect the losses as much as possible...

any comments or advice would be appreciated,

regards M