An excellent comment was recently posted by learningNewIncome which has got me thinking. Here it is:
"PC - still learning here so i may say something totally stupid. You repeat the importance of buying protective puts... i understand the reasoning of the protection - my question is: would it not be better to sell puts on a short index ETF? you dont have the time decay of buying puts on the normal index. ??"
What is your opinion? Which serves us better? My initial reaction is mixed. I love having time decay on our side rather than working against us. On the other hand there is unlimited risk in the event the market rallies. [Note: some astute commenters have pointed out that this will not provide the hedge we need to protect against a market crash. We would only get to keep the premiums collected. The post does raise an interesting new strategy to ponder.]
"Adjusted for Inflation, Dow's Gains Are Puny" WSJ
10 minutes ago
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7 comments:
I think the response misses a critical point. Consider a simple example. If the market is at 100 and you want to protect against losses below 80 you could buy a put option at 80. You are only exposed to a maximum loss of 20 plus the cost of your put.
On the other hand, lets say there is a short ETF trading at 100. If the market falls below 80 the short ETF will rise in value. If you sold a put on this short ETF the put will expire worthless and you would keep the premium but this does not protect you from the downside risk which you initially wanted to hedge against.
In other words, think about this like you would currency options. Buying a put on the long index would be like buying a call on the short index. Selling a put on a short ETF is like selling a call on a long ETF. These are the equivalent trades. There are no free lunches. So you could sell a call on the index, but if the market falls all you get is the premium... not the downside protection.
excellent points..thanks for the comment
Yeah, I would consider the sold put on a short index as counter productive to a protective put on a normal index.
The reason for buying the put is to protect in case the market falls off a cliff (as has been happening quite a bit lately). If the market drops, the puts we sold on the short etf don't protect our sold puts on other securities. They may have generated some profit, but if the market rises (which we hope it does using this semi-bullish strategy) these short puts could end up being problematic.
Although this does bring up a different strategy with selling puts on short etfs and protecting them with buying calls on a regular index, hmmmmm...
Andrew - yes, I think the strategy is worth a closer examination. As far as hedging goes I'm sticking with the protective puts...
Hi PC,
In this volatile market, I really believe the premium we pay for hedging is really worth it. The other problem with selling puts on short leveraged ETFs is the time decay on the ETF itself which makes it more likely to hit the put strike price in the long run. Theoretically, I am a bit concerned with how to effectively hedge with protective puts. I am also using SPY but always question myself:
1) Do I have enough put options?
2) What if I am hedging too much canceling all the profit?
3) If the market crashes, wouldn't the 3X ETF's such as ERX crash 3 times more than the SPY index? Let me give an example:
a) Sold 4 March put contracts of ERX strike $20 for 4*1.5*100 = $600
b) Bought 2 SPY March puts strike $70 for 2*1*100 = $200
Suppose SPY hits $65 sometime in March and the put sells at $7. If you sell the puts, you will have $1400. Now as a rough calculation, if SPY has dropped 23%, chances are that ERX would drop 3 times i.e. by 69%. Then ERX would be trading at around $12. The loss from ERX would be 4*6.5*100 = $26000
This is what scares me, although I have already made a similar portfolio.
I think we should probably have a combination of hedging in our portfolio. One thing that may help in a crash is probably buying short ETF call options. They will definitely skyrocket in case of a crash. I am really confused. Maybe just a strangle play on a volatile stock with small amount of money would be the best bet instead of all these risky jobs. I am really concerned.
Smart - always good to hear from you. You raise some excellent points, however, I think your ERX calculation is 2600 not 26,000? So you could buy 3 or 4 puts and you'd be fine. Or how about buying more and selling some at the next drop and keeping what you need for protection.
The problem I see with buying short ETF call options is that the way the ETF's are calculated daily it might not be enough protection.
These are great discussions. Thanks
Thanks PC. You gave me some more glimpse of hope out there. You are right. With 4 puts, the portfolio will be saved. It is an art to gain some money in this market. By the way, the idea of selling puts on short ETFs is similar to doing a deep in the money covered call on short ETFs if you are bearish for the next month. That might work too, although I don't like it.
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