Friday, 18 March 2011

buying puts as protection.

Buying options does not reduce your risk.

It substitutes some risks for others, you reduce your immediate price sensitivity and replace it with time sensitivity that is less intuitive and harder to manage for a normal portfolio manager. The lottery like returns tend to mean that buyers emotionally remember their winners rather than the thousands of small losers.

Selling options does increase your risk.

It introduces risk and pays a slight premium for doing so. Unless you have a very long time span, and enormous amount of wealth or are trading with OPM in a diversified and institutional setting, you are not going to capture that risk premium, and if you are a retail investor your commish will have turned that premium into a discount quicker than you can say inverted skew.

Howard Lindzon made a comment today (actually in Feb, have been meaning to finish this for a while) that is perhaps prescient; "after the run up maybe its time to look at buying some puts for protection". Having looked at this problem from more than a few angles while running a "tail risk protection book" for a two billion dollar multi strategy fund its one that has given the Raven a few black eyes and hopefully some robust insight.

Its almost always about the timing.

If you buy a boat load of at the money (ATM) puts and the market pukes, you're going to make money. The issue is that if you've got timing like that, well then who needs puts, just short the bugger and get your beach shorts ready because you're not going to have to work hard again.

The reason you buy puts its two fold; 1) not to get your face torn off by the market roofing it 2) which is very similar to (1) but to stop yourself getting stoppped out on a short. or 3) for implicit leverage, which is actually 1&2 together.

So you've skipped to the conclusion, bought your puts, and have been wearing your lucky underpants for the last month, the market is 5% higher and your puts are worth the square root of not a lot, the market actually does crack and you're mentally banking it, those puts must be worth something now, right? for some reason hitting shift-F9 is making no difference to your pnl??? WTF? what went wrong?

Puts don't give you the luxury of not having to get the timing right, if anything it complicates your pnl, introuducing even more timing risk and path dependancy. A "good" (read sucessful at selling centipeeds (a trade with lots of legs, which means lots of commission) to his clients) broker will handily pop up and suggest all sorts of options to sell against your put buy in order to reduce the "cost", by which he actually means the cashflow on day one, it certainley doesn't ever reduce the real cost, will show why it doesn't work in another post.

The paths that you will make money buying puts, you'd have made more money being short. The only advantage is that if the market has continued to go up you'll have lost more on your shorts.

So the first exploration in this space was to design a product that the Raven would have liked to buy at a reasonable price, ie some sort of look back put, ie a product that has a payoff equal to the (price at maturity - max price in lookback period). Well how much would that cost? and thinking back to the days of being on an exotic option desk, how would one hedge that with vanilla options? Without getting into too much fancy mathematics, or hedging strategy its just a good idea to think about what sort of paths will generate interesting payoffs;

1) close today is the market high and it sells off from today onwards, well then the price would equal an ATM put today
2) more realistically, the market rises, and then sells off, a basket of put weigted by the probability of that price being the maximum reached and the remaining time to expirary. so clearly the upside probability makes this product more expensive.
3) the best pay off profile would be a long period of a strong uptrend... with a '87 style crash on the expirary date.

Clearly there isn't a static hedge for this position, but its easy to think of a few dynamic strategies that would approximate that payoff, the simplest would be to buy an ATM put and slightly more shorter dated upside calls, using the profit from any move up on the upside calls to roll the strike in the ATM put up. One could also decide to implement a delta hedging scheme, which would be very similar to the portfolio protection scheme's that failed so drastically in '87. Any dynamic strategy in options is a wet dream for your broker, and a killer for your portfolio, you'll pay bucket loads of commission and for very little effect.

Statistically looking back these strategies would have cost about 3.5%, with a maximum upside profit of about 35% for 3 months of protection. The cost of which annualizes but your upside doesn't, so "hedging" your book would cost you 14% a year. One would have to believe the market has the potential to be a lot higher and the potential for it to be a lot lower, or more precisely that there is a large amount of uncertainty for these strategies to be worthwhile. In which case you're actively betting on volatility rather than actually reducing your risk.

The single best way to reduce risk, is to reduce all your positions proportionally.

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