Wednesday, April 20th, 2016

How to Hedge Index options trading- Protecting Profits and Trading Capital

How to Hedge Index options trading- Protecting Profits and Trading Capital

Its a well known secret for fund and portfolio mangers. Fund Managers regularly spend a portion of their trading portfolio protecting against eventual losses in case the markets drop suddenly causing pain and havoc to their portfolios. Its called portfolio insurance, and its like a monthly bill, just like your homeowners fire insurance. Its something they wouldn’t want to have to use, just like you would like to have your house burnt down, and utilize your fire insurance premiums. Portfolio insurance is a whole new topic for the bigger investors, and the ramifications of using it and techniques used to employ such a strategy are far more detailed.

In our case when we trade index options, these indexes are nor exempt from daily stresses of worldwide events occurring 24/7 around the world. Market events currencies, wars, oils, political unrest and domestic events all influence stock market trading and indexes daily.

Here is a very simple strategy that can be employed for pennies on the dollars. In turbulent markets when the likelihood of a market crashing down 300 -400 points day after day, we simply buy put options on the pennies when executing our bull put spreads. Remember we don’t buy call options to protect upside thrusts of indexes. The reason is simple, when the market collapses, VIX index ( fear gage) derived from SPX puts options spikes and the volatility increases which makes far out puts to increase in valuation rather quickly and abruptly. As the markets cascades down, and your bull put spreads starts doubling, so do these put options, and thereby hedging your losses, with some gains, and making you recoup some losses , or clearly avoiding losses after a nasty sell off. Its always a good idea to be prepared for the rainy day.

Simply buying NDX, RUT, SPX puts when a new trade is initialized for pennies 0.01 to 0.5 cents costing $1 to $5 dollars in the amounts of $100-$200 taken from out from the credits received will offsets several hundreds dollars of losses down the line.

Lets suppose a bull put spread on RUT index gives you a credit of $1500 in your account, I would take $150 and buy these puts for $1 to $5 dollars and that could be 150 or 30 puts in your accounts. If all goes well and markets don’t cascade down, in a waterfall sell off till expiration, these puts options will expire worthless, and you will gain nothing. Its like paying a monthly fire insurance premium. But in case the markets do sell off and your bull spreads are threatened, these puts gather momentum and due to higher volatility spikes in VIX are now valued $10 to $25 and with a great number of them, its lots of money that you can take and close the trade or offset your losses.

The formula for placing these hedges is complicated but a simple plan is something that one can employ instead of having nothing at all, it is still a superior strategy. If you really like to be accurate in terms of number of trades and contracts of puts to be employed for your portfolio insurance, you can take a peek at www.cboe.com and read further on the subject.

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Comments

28 Responses to “How to Hedge Index options trading- Protecting Profits and Trading Capital”
  1. Nick Beardshaw says:

    Great article on protective stops and trading. I have been there and lost money when I did not use stops. Thanks

    Nick

  2. Hedging is always the best way for people to protect their capital and profits. We’ve had plenty of traders make a huge profit by accident just by having an appropriate hedge.

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  4. Fitforlife says:

    Thanks for the article on hedging and sharing your August trades. Do you always use 10% of your Bull Put credits to hedge your bull put trades? Do you buy the puts on the same index as the credit spread trade. I once just bought puts on stocks like MSFT, Intel and TXN because they were only 2 and 3 cents. Many months I made money selling these puts right before expiration.

  5. alliance says:

    There is no such thing as always in trading. When the markets are cascading down like a waterfall, I would buy protection and give up some profits to shield capital or get out of the trades entirely.

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