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At 1:31 PM -0700 7/3/01, DH wrote:
>Well, then we've gone in a big circle. The starting point of the
>exercise was to hedge the futures trade with options. If you cover your
>futures trade when the options are deep in the money, you're booking a
>big loss on the futures trade and *hoping* the big profit on your
>options position won't disappear before expiration.
Let's consider several examples.
Case 1: You are long one SP contract which has an equity exposure of
1250 * $250 = $312,500 and are holding this position overnight. Some
world crisis occurs overnight while you are asleep. The next morning
futures open limit-down. The limit keeps moving down. You cannot get
out. Eventually, your broker liquidates your position with huge loss.
Soon after, the world comes to it's senses and the price moves back
to near where it started but you are out with the huge loss.
Case 2: You are long one SP contract and long one SP futures Put with
a strike price 5% under the market in the same account. The crisis
occurs overnight, the market tanks, and your Put becomes
in-the-money. You account loss is limited to the 5% or about $15,000
which is less than your account balance. You broker does nothing. The
market comes back and your account recovers most of the loss. Some
time later you exit both positions.
Case 3: As in Case 2 except that the market stays down and your Put
remains in-the-money. You now have to unwind the two positions in
some orderly way but there is no rush since your are "market-neutral"
so long as the Put is in-the-money. So you wait for some opportune
time and exit both positions. Your loss is limited to the 5%
($15,000).
Case 4: You are long one SP contract and long one SP futures Put with
a strike price 5% under the market in the same account. Nothing
unusual occurs in the market. You sell the Put position sometime
later with some loss in the time value. This loss is the "insurance
premium" you paid for the "insurance". But since you had the
insurance in place, you were able to trade larger positions and hold
positions overnight safely so you made enough more money trading the
larger positions than the insurance cost you.
Case 5: Real estate is appreciating rapidly and you have an
opportunity to buy this rental property for a $312,500 with very
little of your own money. You buy the property and buy a fire
insurance policy to cover the value. The property doesn't burn down.
You sell the property later for $400,000. You made $87,500, less the
cost of the fire insurance. You obviously would not have even
considered doing without the insurance.
Think about it...
Bob Fulks
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