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Can we get real about Options on ASF?

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gg
 
…. The Addict in me ….
Normally play ASX200 options but ….
….. For transparency …. and to keep the discussion ‘busy’…

A ‘real time options trade’.

I have a few US dollars spare in my account and decided to play a ‘directional’ play on TSLA earnings .

A risky trade, but I think earnings will be disappointing and the SP will drop.

For the newbie …..

current SP is 150 as I post.

The Implied volatility IV is high (the market believes the SP will move ‘a lot’ over the earnings announcement) thus the price of options is ‘elevated’. Thus to buy (BTO) is ‘expensive’. Not a trade I normally do. I’m usually an option seller (theta decay - look it up)

Directional play: ‘I’ think TSLA SP will go down (I am betting on a direction, down is what I think). when earnings announced on 23 April. Buying a 141 put means I think SP will drop.

If it drops below 141 I can sell at 141 and buy at market price (lower than 141) and make a profit. The difference between 141 and the SP.

If it doesn’t drop below 141 my maximum loss is the premium I paid to buy the option, a defined loss. Good to know and control your risk.

I bought a put at SP of 141 for 26 April.

ie. I have bought the ‘privilege’ to sell TSLA at 141 if I want at anytime up to 26 April. I have paid (debit) for this privilege a premium. Cost to me.

This means I can buy TSLA at 141 anytime before 26 April.

A little bit long winded, but trying to help those that are learning options.

I believe TSLA SP will drop when earnings are announced (23 Apr).

EDIT : spelling due to red wine.

Gunnerguy.
 
Thanks a lot , I will have a few busy evenings
 
So Mr Gunner has put up a trade. Which I always enjoy seeing, win or lose. You have his thinking on why he placed the position.

Here is where Options can get tricky. The following is not meant to be critical of the trade, rather how I would analyse the trade:



The starting point is a chart.

What is occurring? Obvious downtrend. That pivot point at $136.68 is an ideal target.

How long will it take? Now there are ways to 'measure' a move in time and price. I'll dig these out later. I recently traded KOS and got the 'time required' wrong. Probably needed an additional week. The point is: you need on a directional trade an estimate of the time required because you have an expiry date.

Next volatility:



Now the general rule is: buy low volatility, sell high volatility. This is to avoid the IV crush. @wayneL used to go on about this forever on Reefcap and I used to think, WTF is this chap on about? Until I got smashed. IV crush is a thing.



IV is at 87%. Which going back to the IVol chart, is high by recent standards.



Also confirmed by the calculator.

To get to the lows of 40% the price would need to be: $1.00



Now earnings is in any stock a high IV event. If earnings are:



Then the premiums should stay elevated until after earnings are announced. Then, IV drops significantly.

What is the market saying the 'probability' is that TSLA sees $141?



Market says 34%. delta for all intents and purposes = probability.

Making a profit from all of the above:

With a straight PUT purchased at a high IV the market needs to get to $141 or lower pretty sharpish.

If the PUT were held to expiry all that is left is the intrinsic value. All the extrinsic value (time/theta, vol/vega) disappears. So assuming a purchase price of $4.30 to make a profit we need +/- $136 stock price.

A vertical is where you sell 1 and buy 1.

So in this case:

Buy 1 PUT at $141 @ $4.30
Sell 1 PUT at $138 @ $3.30

Net debit = $1.00



Calculators are a good way to test various strategies.

Here is the risk graph:



Ignore the top readings.

The risk graph for a PUT










In this case I would go with the vertical.

Now the beauty of Options are, if you don't like your first position, you don't necessarily need to close it, convert it.

To convert to a vertical (if you wanted to) simply sell a PUT at $X to convert to a vertical.

jog on
duc
 
For those that don't want a directional play: market neutral, which would be myself.

A pairs trade:



This works because:



PLD is the biggest holding in the ETF at 11%. They tend to track each other over time. A 2/3 month expiry cycle can normally work:



Weight them 3:1 XLRELD for price. You can also weight them for vol. I just use price.



Add 1 long vertical PLD
And 1 short vertical XLRE

You can of course add a risk graph to illustrate further, but you will need to draw 2 separate graphs.

The market closed before I could place the position (while I was working out the details). So possibly look at it Monday.

Now of course you can lose on both legs. The spread gets wider. LOL.

jog on
duc
 
TSLA Trade

Bought the 141p (28Apr) a@ 3.95. SP 150
At close SP dropped to $147.05, -1.9%.

141p is now 4.45 a gain of 0.5.
1 cintrct gain of $50, cost of $396 (with fees).

If the market was open, and the price of the put was 4.45 I could sell to close (STC) for a profit of $50 per contract.

So return would be $50/$396 = 12.6%.

Let’s see what happens on Monday.
Hopefully Musk something silly over the weekend and the price drops even further.

The option is ‘out of the money’ (OTM) as in if exercised now ‘sell at 141’ and SP at 147, the contract would not make money. The option has no INTRINSIC value, however the price is 4.45 all of which is know as EXTRINSIC value.

Extrinsic value is based on time left to expiration, volatility amongst other things. Basically there are traders who believe the SP could still fall below 141 before/by 28 April upon which the option would be ‘in the money’ (ITM), ie. have some intrinsic value.

Gunnerguy
 
TSLA news published in sat 20th April.
Posted by @Chipp on the TSLA forum.


Reducing price of Tesla cars by $2,000.
Reducing revenue possibly but certainly margins.

Will the SP drop in Monday and thus increase the value of my owned 141p ? Possibly.

Article also, however, states they are laying off 10% of their staff. This would reduce costs so may actually cause the SP to go up.

Who knows.

The dynamics of option trading …. the release of company related news and the affects on option pricing seen right before your eyes.

Gunnerguy

Thanks @Chipp
 
Gunnerguy said:
Are these credit or debit trades ? Sorry I can’t work it out.

Gunnerguy
Click to expand...


Mr Gunner,

They are all debit spreads. However one or two could be placed using PUTS as credit spreads. Wherever you see a vertical, you can reverse it using the opposite (CALL/PUT) from a debit spread to a credit spread.

It will change the R:R of the trade.

As an example Dominion



Same expiry and strikes, but different R:R characteristics.

By far the better trade is the CALL vertical which is a debit spread.

Diagonals are an interesting trade. I don't use them much myself, but they have value when used correctly. The correct use is when you have a bull chart, but a bear market. It is a way to mark some time and reduce the cost of an outright bull position, waiting for the possible break higher later.

So CVE



So if at expiry of the sold CALL the chart still looks good, you just let the sold CALL expire worthless and hold the long CALL for whatever it gives you




So you reduce your risk for unlimited upside.


jog on
duc
 
Buy to Close my 141p (26April) at 7.12.
I chickened out and took my profits.
I tried to sell at 9.50 at open but unsuccessful. Then 9.1, 9.0, and several more lower prices.
Eventually closed at 7.12 at 21.41 (Perth time)

Summary

18/4 BTO 141p @ 3.95. SP at 150.
22/4 STC 141p @ 7.12. SP at 142.
Gross gain = (7.12 - 3.95) = 3.17. (USD)

I could have got more if I closed at the start of the day (8.65) . I put my buy price at 9.00 which was too high (greedy).
Price now (22.31) is 6.35.



NB. The price increase was due to the dropping of the SP and not the 'volcrush'.

I will revisit after earnings announced and see what happens to SP and price of my 141p (which I sold to close my position).

Gunnerguy
 
I'd like to keep this going @wayneL and maybe share a bit more insight around Professional Options Trading.

I think many would be surprised about how the bigger end of town use options. I'm about to recite cliche terms here, but they keep it simple (K.I.S), don't overtrade, are methodical, have patience and often times will only trade 1-5 underlying's (staying in their lane). There's no question they understand the assets they trade and are experts - but they stick to a specific part of the market they understand well and don't do much else.

The main types of Option contract use I've seen is:

- Enhancing stock portfolio return strategies - by hedging with long puts, selling calls against stock or selling cash secured puts with intent to purchase the underlying.
- Momentum trading - using spreads to trade momentum on underlying stocks and taking advantage of the natural leverage in options, Bear Call and Bull Puts in High IV, Bull Call and Bear Puts in Low IV
- Delta Neutral Trading - using time decay, Implied Volatility (extrinsic value metrics) to their advantage. Straddles, Strangles, Butterflys, Ratio Spreads etc. This is like building a portfolio of options together and managing as the underlying moves.

At the end of the day, "Options have Options", they're the most flexible trading instruments around. Traders use them for different goals in mind. Where were you thinking of taking this @wayneL ? So many different concepts to cover. I might be able to assist with somewhat of a crash course structured with what people want to learn more about.

A fantastic resource is a book called "The Options Course: High Profit and Low Stress Trading Methods" written by George Fontanills; I would recommend getting a copy for anyone interested in how the pros trade. Talks about pretty much everything from psychology, strategies, entering and exiting trades, how to manage etc. so much great information in this one. - No required knowledge

One passage I've bookmarked is this:



Volatility should be the essence to build your strategies.

Gunnerguy said:
Buy to Close my 141p (26April) at 7.12.
I chickened out and took my profits.
I tried to sell at 9.50 at open but unsuccessful. Then 9.1, 9.0, and several more lower prices.
Eventually closed at 7.12 at 21.41 (Perth time)
Click to expand...
@Gunnerguy hindsight is an amazing trading tool, good thing you got a profitable exit because after-market TSLA is up big, nice one to you and good to watch as an observer how you went about it. Interested to get your thoughts post trade on this.

Cheers,
VB
 
Haha "options have options", I love that.

I just want to take it wherever it goes. KIS for sure, but I do firmly believe that the more people have an understanding of the Greeks, the less mistakes they are likely to make.

Most retail traders start with either covered calls or long calls puts (the covered call being nothing more than a synthetic short put).

From those simple building blocks people can then make it as complex as you like, though keeping it as simple as possible is often better... More complex, more legs, more adjustments equals more contest risk. That can be toxic to returns.... Which goes to your point about resisting over trading.

I reckon learning about how they do it on the other side of the Ledger can only help us retail traders. So fire away.
 
Just want to be clear, my experience and observations have come from professional traders, meaning mainly funds and individual Full-Time traders, who are on the same side of the ledger as you or I. On that note though, Options participants should absolutely be aware of the role of market makers (the other side of the ledger), what their job is and how they make money. Super important to know how the structure of whatever market you're trading works:


Managing a Market Makers book is quite a lot different to your own portfolio, as they're obligated to provide liquidity into the market. How they manage risk, and their own portfolios is a lot different to our side, as they take thousands of positions then work out how to hedge all of them. - not my expertise. If anyone has this experience, would be great to hear from you!

All that aside, I'd say that the traders who excel at this take trading seriously, run their strategy like you would run a business. Have a plan in place, test your strategy in the market, make adjustments, start small and scale up. Know what triggers you to enter and know when to exit.

Maybe I'll dig into exiting a trade - most people talk about getting into a trade, but not how to get out. What I don't see is good traders holding options until expiry (as a generality). Now you may think that's the idea of selling premium, for the options to expire worthless, but the opportunity cost (and margin) to hold a sold put that's at 90% profit for another 3 weeks, vs rolling closer or closing and using buying power for something else, can add up. Depends on the trader, but some will close at profit targets, 50%, 75%, 90%, or at support / resistance lines on the chart.

Trade going against you? - manage early - the maximum loss on your spread doesn't have to be your maximum loss for your trade. If the trend reverses, take the Loss and re-position, maybe that's a break of a key level, or you predetermine to exit if the strategy is at a 2x loss, or 3x loss to your entry.

Another interesting fact about options, the value of an option is affected by the Risk-free rate from central banks. Stock covered positions - like covered calls, where you're not providing cash margin, are more effective when the interest rate is higher.

Just my perspective on this, I'd love to hear from people that do the opposite and have success!

Cheers,
 
So Mr Gunner's TSLA trade:



The probability of what just happened, ie. poor/average earnings and stock gaps higher, was pretty low, yet, it happened.

Some takeaways had Mr Gunner held his position to after earnings and/or expiry.

(i) just for the moment assuming that Mr Gunner had held onto his Option position as opposed to being short the common stock:

Mr Gunner's prices:

26 April Expiry 2024
Strike $141
Price paid $3.95
Price sold $7.12

Current prices:



Pretty much a 100% loss, so $395.00

As opposed to a common stock position of: short at $150 for 100 shares

Loss = $1150.00

Or 34% of the loss of a stock position.

(ii) So Options, even when using the most basic position, long Put (long Call) provide enhanced risk management. No need to place a stop loss, can still easily manage the position (enter/exit/modify) once entered.

Question for discussion:

Had Mr Gunner decided not to sell-to-close the position, but wanted to modify the position to hold through earnings, but protect some of his profits, what, if anything, could he have done to modify his position?

jog on
duc
 

I think that the way to clarify exactly what you have on your hands, especially when you start building weird and wonderful combinations that you are convinced offer different risk/reward characteristics is to:

Plot it as a risk graph.

Amazing how many esoteric combinations match an already existing basic position. LOL.

Back in the day I created this amazing combination of legs that boiled down to I think a butterfly.

Mr Blake:



Market Makers provide liquidity....until they don't. Always in a liquidity event, by definition, liquidity disappears. If you are on the right side of the move with Options, wonderful. On the wrong side, as long as you have managed your risk exposure correctly, you will lose but live to fight another day (assuming defined risk). Of course if you are naked short, well that's another story entirely. You may be carried out on your shield.

As to plans: What is the absolute worst outcome that could occur? Plan for it because 1 day it will.

An underappreciated risk: your broker blows-the-fu*k-up. I had it happen to me. Many will remember Zip-Zap from Reefcap. He opened a brokerage here in NZ. It blew up, some fraud from the Australian side. Took me 2yrs+ to recover $0.70 on the dollar.

However I have multiple individual accounts just for that eventuality.

I also have reduced my individual exposure via returning to institutional trading for a prop. firm. Something to consider.

Holding to expiry: I like to hold to expiry (generally). I know TastyTrade advocate to close once you reach 60% of target and/or 20 days prior to expiry (whichever comes first). Lots of YouTube videos on this.

Managing: now this is a pretty advanced if you want to modify positions. Straightforward if you just close. Worthy of discussion.

Riskfree rate: Now that rates are higher, it is again a 'thing'. For a while there at ZIRP it was largely ignored. Good point. Also dividend paying stocks can fall into this category.

jog on
duc
 
Last edited:
So an article on COLLARS:


Uber's business is doing extremely well. It has reached escape velocity – the company's expenses have grown at a slow rate while its revenues are growing at 22% a year. This caused profit margins to expand and earnings and free cash flows to skyrocket. Our investment in Uber was based on the assumption that its services would become a utility – just like water and electricity. The company's name is synonymous with ridesharing.

I must confess that the biggest risk to our investment in Uber is me. Yes, you read that right. Uber has an incredible growth runway. It is not just going after ridesharing and food delivery, where it still has plenty of room to grow, it is also making serious inroads into the grocery market. It has terrific management that is putting a lot of daylight between Uber and its competitors.

On one hand, we are managing your portfolio as though we were managing all of your net worth (this is actually the case with most, though not all, of our clients). Thus, we see it as our fiduciary duty not to let one stock dominate the portfolio. Bad things do happen to great companies.

On the other hand, we know that some companies which have a high return on capital, a dominant industry position, and a very long growth runway reward those who can maintain long-term focus. There are very few of those companies out there. Uber is one of them.

This stock requires an incredible ability to sit on your hands (not selling or trimming), which is very hard, especially when the stock more than doubles in less than a year and becomes a very large position in the portfolio and a good chunk of the company’s earnings power lies far into the future.

Therefore, we did the second-best thing to trimming your Uber position; we hedged a portion of it using what is called a protective collar.

Before, I get into the structure of this trade, let me discuss options.

As a shortcut, our brains categorize words as negative or positive. Psychologists probably have a fancy name for it, but I’ll just call them cognitive associations. For most people, derivatives and options are associated with giant Wall Street blowups and thus have a negative association.

Although cognitive associations can be useful (most people should not touch derivatives with a ten-foot pole), they can also be harmful, as they may lead us to overlook nuances. Warren Buffett famously called derivatives "weapons of mass destruction" in the late 90s, but a decade later he amassed a huge position in them. Many things are neither negative nor positive; it is our use that makes them so. Just as a hammer can be employed as a murder weapon, it can also be used to build a beautiful birdhouse.

Our approach to options comes from our guiding principle: Do no harm (don’t blow up). We are very cautious in opportunistically using options to reduce risk in the portfolio (usually as hedges). Though use of options may still lead to losses, these losses should be bearable and not life-changing.

Let's discuss our UBER hedge. In simple household terms, we sold a ceiling and with the sale proceeds bought a floor.

Let me explain.

When Uber was trading at $80, we sold (wrote) a call option at $100 and received a premium of $6. This created an obligation for us to sell our Uber shares at $100. We only implemented this in accounts where we own Uber shares, so it is an obligation that we can easily fulfill. We would have reduced our Uber position at $100 anyway. Therefore, we simply got paid for something we would have done regardless.

We took this $6 and used it to buy a put at $70 (an option, not an obligation to sell at $70 – think of this as buying insurance). Both contracts have the same expiration date, December 2024. At essentially no cost, we created a 12.5% floor under our Uber stock in exchange for a 25% ceiling. We love the asymmetry in this trade. Typically, put options are more expensive than call options, but not in today's euphoric market that has been continuously rising. We took advantage of this by putting this trade on. This is how we use options sparingly and opportunistically.

If UBER goes down to, let’s say, $55, the value of our shares will decline by $25 (from $80); however, the price of the put option will go up $15 – offsetting a loss on hedged shares.

We only put this collar on a portion of Uber shares. As I have mentioned, Uber has a very bright future, but risks do happen and thus we need to manage individual position sizes.

We may also use options to hedge our portfolio in the future. I wrote about it in 2018, and will discuss it below.
Though first written in 2018, this article remains relevant to this day.

We always look at our investment process and ask ourselves, “What can we do better?” How can we increase returns and lower risk?

One way: We can hedge a portion of our market exposure with put options. Put options are contracts that trade on an exchange which give the buyer (us) a right, not an obligation, to sell stock (or Index, ETF, or other security) at a specific price for a certain period of time. Put options are cash settled, so when we exercise it or it expires we get cash in lieu of its value. Buying put options is very similar to buying hurricane insurance. We pay a premium, and that is the only cost we bear. Let's restate this: The only risk we take is that the hurricane doesn’t hit or, in our case, that the stock market doesn’t decline, in which case our premium was “wasted.”

When you buy hurricane insurance you don’t suddenly start wishing for a hurricane, but you do get peace of mind from knowing that if Richard or Betty (we name hurricanes like we name pets) pays you a visit, the insurance company will restore your house to its original state.

We look at options “insurance” the same way we look at any asset: It can make sense at one price but make no sense at another. As you will see, at today’s price they make a lot of sense.

For the sake of simplicity let’s make a few assumptions: First, your portfolio is 100% correlated to the stock market. Second, your portfolio is 100% invested. And finally, let’s assume we’d be buying put options to insure your whole portfolio. These assumptions will simplify our example – we’ll modify them later.

Based on our assumptions, we’d buy put options on ETFs that track a particular stock market index – let’s say the S&P 500. In January 2018, for example, if we bought options on the S&P 500 ETF, SPY, that expire in one year and that were 5% out of the money (they wouldn’t start paying us until the S&P declines 5% or more from that point – think of this 5% as our deductible), the cost of insuring the entire portfolio would have been about 4% of its total value. For a $1 million portfolio it would be $40,000.

If the stock market decline is greater than 5%, the insurance kicks in. After a 5% decline the value of our stock options starts going up proportionally to the decline in the portfolio. If the stock market falls 20%, the $1 million portfolio declines to $800,000, but this $200,000 loss is offset by the appreciation of our put options, which go up by roughly $150,000. Thus the value of the portfolio is now $950,000 (remember our 5% deductible). Actually that number will most likely be less – somewhere between $910,000 and $950,000, because we paid $40,000 for the put options.

Without getting too deep into the weeds, the price of an option is driven by two additional factors: time (options are not good wine; they get cheaper with age) and expected volatility, which we’ll discuss next.

Let’s say you are insuring a home somewhere on the Florida coast. The general formula to calculate the cost of insurance is probability of loss times severity of loss. According to a study by Colorado State University, the climatological probability that the coast of Florida will get hit by a major hurricane in any particular year is 21%, so once every five years or so.

A 21% probability doesn’t mean that a hurricane will pay a visit every fifth year; no, it actually means that over a 100-year period there will on average be 20 hurricanes hitting the Florida coast. Hurricanes may, however, decide to pay a visit two or three years in a row and then take eight or ten years off.

21% is the number an insurance company uses to figure out the intrinsic cost of the insurance. But this is where we have to draw a distinction between climatological probability of loss (intrinsic or true cost) and expected probability of loss.

There are other factors that go into the total cost of the insurance contract, including the size of the policy, its duration, and the deductible. But if you hold all these factors constant, the only number that fluctuates due to supply and demand in the insurance market is the expected probability of loss.

A year after a hurricane, homeowners are still licking their wounds from last year’s Richard or Betty. The pain is so recent that those who were hit expect that hurricanes will happen a lot more often and thus the expected probability (in the eyes of these consumers) rises to … pick a number; let’s say 50% (a hurricane every two years). (The insurance industry may have had its capital depleted by recent hurricanes, which will also drive prices higher, but we’ll ignore this factor in our discussion.)

However, if there is no hurricane for a while, let’s say for eight years, the memory and the pain of the last hurricane fade away. A new wave of homeowners moves in, who have seen hurricanes only from the comfort of their leather couches on the Weather Channel. Now the expectation of another hurricane drops to, let’s say, 10% (a storm every ten years).

Thus, though expected probability and thus insurance cost has fluctuated dramatically from 50% to 10%, intrinsic value has not changed; it is still 21%. This example is extremely oversimplified, but the key point is still the same: A rational homeowner would want to buy insurance when no one expected a hurricane to visit Florida and lock in that price for as long as possible. If you are an insurance company you want to write as much insurance as you can when hurricanes are priced at 50% expected probability, and you want to be out of the market when they are priced at a 10% probability.

In the options market, expected probability of loss is expressed in terms of the volatility that is priced into options. A long bull market (despite some small interruptions) has eroded even the most unpleasant memories of the 2008 decline. Fear has been replaced by euphoria that has been further amplified by the steady daily appreciation of stocks. The mindset that markets will never decline ever again has gradually seeped into the collective stock market psyche. This is why volatility is cheap! How cheap? Average volatility priced into options since 2004 was about 18%; today it is at 10%. In 2008 it reached 80%, and it has reached 40% a few times since 2008.

Volatility is quickly becoming one of the most interesting assets in the otherwise not very interesting stock market. But the situation in the stock market is even more interesting than in the hurricane insurance market.

Stock markets are fueled by two often contradictory forces: human emotions and movement towards fair value. Human emotions may divorce stocks from their fair value for a considerable period of time, but movement towards fair value can only be postponed but not suspended. During bull markets greed begets greed and stock market valuations go from cheap to average to high to super-high to extra-super-high – we are running out of superlatives, but we hope you get the point: Valuations march ever higher … until the music stops.

It is hard to know what will trigger the “stops” part, but in the late stage of the bull market, stock market behavior is driven less and less by fundamental factors and more and more resembles a Ponzi scheme (though market commentators come up with plenty of rational explanations to wrap around their “this time is different” narrative).

Stocks march higher until the market runs out of buyers and collapses under its own weight. This is how movement towards fair value takes place – except that, historically, markets have rarely stopped at fair value; they have fallen to levels well below fair value.

We’ll address the market’s current (over)valuation further on in this letter.

We are not meteorologists, but we believe there is an important difference between hurricanes and stocks. Just as when you flip a coin each flip is an independent event and completely unconnected to the previous flip, hurricanes are independent events – just because Richard paid a visit to Florida last year does not change the probability of Betty’s appearance next year. Betty is not aware of Richard's past misdeeds.

In contrast, the probability of a significant market decline is not constant; it is dependent on past movements of stocks. As markets stretch higher and higher, bulk of the appreciation was driven by expansion of price to earnings. Market valuation which was already high went higher. The gap between the price and intrinsic value creates a rubber band-like tension. The wider the gap the greater the tension and risk of eventually embarking on the return trip towards fair value.

Thus, in the case of the hurricane the climatological probability of 21% of loss remains constant no matter whether Richard or Betty appears, but in the stock market the probability of a sharp decline (an equities hurricane) increases as the gap between price and fair value widens.

In other words, today the value of volatility has increased while its price is making new lows. This is why we believe volatility is one of the most interesting assets we see now.

We are not market timers. We have no idea what the stock market will do today or tomorrow, but we look at buying put options as an opportunity to hedge our portfolios with what we believe is significantly undervalued insurance.

Let’s delve into the practicality of our hedging strategy and modify some assumptions we made in the oversimplified example above. First, our portfolios are not 100% correlated to market indices. Considering that we own high-quality companies that are significantly undervalued, we believe our stocks will (temporarily) decline less than the market if there is a significant correction. Second, we have a lot of cash, which doesn’t require hedging.

Let’s say your account is 60% invested. We only need to worry about hedging that 60%. And considering that our stocks will decline less than the market, we need to buy puts to protect less than 60%. How much less? Historically our stocks have declined a lot less than the market during significant sell-offs. Our average portfolio was down 17-18% in 2008 when markets were down 35-45%. Our guestimate, therefore, is that we need to hedge about half of 60% or 30% of the total portfolio. So the total cost of insuring the portfolio against a decline of 5% or greater for a year would be 1.2% (4% – the cost of “insuring” the total portfolio – times 30%).

You can see how this strategy can reduce risk, but can it increase returns? The answer is a bit more complex and has two parts: First, if the market takes a deep dive, our appreciated put options together with cash will have increased buying power, since everything around us will be cheaper. And second, depending on when it happens – how much time value is left in the option – the value of the option may jump dramatically, as the market will be pricing in not 10% volatility but a much higher number – 30%, 40%? – your guess is as good as ours.

IMA’s ultimate goal is to produce good risk-adjusted returns while keeping volatility of our clients’ blood pressure level to a minimum. We try to achieve this through our conservative stock selection, our transparent (sometimes overly long) communication, and now through buying inexpensive insurance on the portion of your portfolio.

Our view on what true risk is has not changed. To value investors, true risk is not volatility (a stock temporarily declining in price), but a permanent loss of capital (the stock price decline is permanent). Our hedging strategy goal is to take advantage of an undervalued asset – volatility – and to decrease your (future) blood pressure just a little.


​



jog on
duc
 
So 3 possible trades to consider for theoretical purposes:



Bullish trade. OXY is Warren Buffett's baby. BRK will continue to support moves higher. It is in the Energy sector, one of the current bullish sectors.



For a sideways move. Possibly has some further consolidation in there.



For the bears. In Medical sector (XLV) which is a bear currently. Low base pattern. Looking for the breakdown.

None of the trades are more than 3 weeks, although various sectors can change quite quickly at times, so always defined risk so that there is no need to do anything. You can simply set and forget. Helpful with those whose psychology is more nervous or wanting to grab profits.

If your position sizes are small, balanced with some bulls, bears and neutrals, with a slight bias depending on the market orientation, then what ever comes your portfolio should work out net positive most weeks. Psychologically, this lets you sit in the trades without constantly needing to monitor or second guess the market, do I hold or fold?

We can check on these trades moving forward. The only one that you should potentially close for profit taking is the Butterfly. A double position can be closed 50% for a profit take leaving 1 trade on to expiry and a free trade. Verticals are usually best left to expiry. That being said, I know TastyTrade recommend closing at 60% profits. Either or.

So unfortunately little to no discussion on:



Options allow you to bet big on a direction and then if wrong, modify/manage/morph into something else entirely. Some (many?) love to use options this way. They 'work' the position until they squeeze a profit out of it.

jog on
duc
 
This is good thanks @ducati916 - not many contributors yet, but if we keep pushing ideas and talk strategy, hopefully more will emerge.

I know of a Full-Service Options advisor (for AUS market) who is keen to start posting his trades for his clients and trade ideas; might convince him to share them & reasoning on this forum too.

I'm interested to know your thoughts on, in your neutral trades, your preference to Butterflies vs something like an Iron Condor (if that's true?). I have some assumptions as to why (flexibility for set up & adjustment) - How do you play a Butterfly after you're in the position? Is it a shorter expiry set and forget as you mentioned above? I could imagine a lot of staring at screen on the final days + assignment risk on the short legs.

I've played around with the "Broken Wing Butterfly", which sets up like this:


Structured as a net credit and allows some directional protection if you don't capture the butterfly zone. I don't enough evidence to have an option on this as of yet, but it shows one of the interesting setups you can achieve with options.

Cheers,
 
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