Options as a hedge for spread betting

[olivertomahawk]

Hi everyone

I am looking at hedging strategies for my spread bets. I currently have a short on the FTSE250, the index I am most highly correlated to, but I also wanted to look at buying an option. I checked on IG Index’s site this morning to get prices for buying a PUT option on the FTSE100 (they don’t seem to offer options on the FTSE250 but I wanted to work out what it would cost roughly anyway).

So I checked three contracts, April, June and September. Please could someone let me know if my calculations are correct? It seems pretty expensive but maybe I am not calculating these correctly.

So I presumed a strike price of 6400, around where the FTSE100 is now.

I want to hedge half of my money at risk, so £22,500. I always start of with 7% stop loss levels on my bets so I thought a 7% drop on the FTSE100 would be a good way to calculate the amount I need. That makes the level I am looking for at 5952 (i.e. 7% of 6400). That is 448 points away from 6400 and if I am hedging £22,500, it works out to £50 a point.

The prices for a PUT buy for each contract are as follows; Apr – 92.2; Jun – 189.7; Sep – 290.3

Using those figures at £50 a point I calculate that the options would cost me; Apr - £4,610; Jun - £9,485; Sep - £14,515. Therefore my breakeven level for each would be; Apr – 6307.8 (1.44%); Jun – 6210.3 (2.96%); Sep – 6109.7 (4.54%)
Is that correct?

If I were to go for one, I would probably buy the June contract which would cost me £9,485 and the FTSE100 would have to drop by 2.96% for me to break even.
Seems expensive but when I look at my current hedge of shorting the FTSE250, I am down almost £6,000 and it has risen by 1.8%, so maybe not that expensive?

Any help, recommendations are very welcome.

Thanks

 

[Hoggums]

Options are an expensive way to hedge positions. And you really need to consider carefully what strike you are going to hedge the position at. The tradeoff is between strike price and how far out of the money the option is. A cheap option hedge won't cost much if the position is profitable - however the hedge will not turn a profit until your future position is some way into loss. It's something you need to work out yourself.

But most important is that you choose the correct option. If you want to hedge a short future position with a long option, then you need to buy CALLS not puts. Put options go into the money when the underlying falls in value.

 

[BobbyBB]

You're better off selling half your FTSE 250 trade, that's the best and cheapest hedge.

Buying options as a hedge is great IF your timing is almost perfect, but lousy otherwise and this is what's likely to happen. Your FTSE position goes down but not enough for the put to go up in value (via intrinisic value, it will also lose via time value). So you'll lose on the put and lose on the FTSe position as well.

Never forget in this game that you're paid to accept risk so if you don't like the current risk reduce the size of the position.

So buying options as a hedge for most people is not the way to go. The time to use options is for betting on direction instead of a futures/spread bet position BUT only when option volatility is at pretty low levels. Then they can be great.

 

[olivertomahawk]

Thanks for the replies.

Hoggums - yes, that is the tricky part - working out the strike price. I am still playing with the idea and doing various back tests on my portfolio to test the outcomes. In the meantime, I have reduced my short on the FTSE 250 dramatically.

BobbyBB - Thanks. Yup, I need some sort of hedge though I think due to a correction coming at some stage. Risk is inherent and unavoidable in trading but I feel that there must be an optimal way to reduce this risk. I just need to find out how to do that!

 

[BobbyBB]

BobbyBB - Thanks. Yup, I need some sort of hedge though I think due to a correction coming at some stage. Risk is inherent and unavoidable in trading but I feel that there must be an optimal way to reduce this risk. I just need to find out how to do that!

What you probably want is what everyone wants, upside potential with no downside potential. Sadly that's impossible. If you try to defend the downside it's going to cost you in money, if you want only upside it's going to cost you in risk.

THE best solution is to realise you cannot have it both ways and therefore cut the size of your position. If you go into the options market and your timing is not perfect you, me and most people are going to wish they'd never heard of options.

The question to ask is what is the great pain (to you), the pain of losing mark-to-market losses or thepain of missing further upside potential (should the market rise). Answer that and you'll know the best solution to take in an uncertain world. For example, if the pain is greater in giving back profits, reduce your position.

 

[BobbyBB]

I have reduced my short on the FTSE 250 dramatically.

That is what I would have done, nice and simple, cash money in the bank with some further upside potential available.

Now be smart, realise you'e taken what you believe to be the best decision when dealing with an uncertain beast (the market). So don't go whining if the market goes up 5% nextweek saying 'I knew I shouldn't have covered' etc. Not saying you were going to whine though :cheesy: