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</x-html>From ???@??? Wed Feb 16 14:29:47 2000
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From: "Gary Fritz" <fritz@xxxxxxxx>
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Subject: [RT] Overnight disaster insurance, take 2
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Status:
I'm still trying to understand how to use options for disaster
protection in a futures position. I've talked to a few people and I
think I understand the ideas better.
Would this approach work? I'm looking at a shorter version of Ben's
option straddle approach -- sell calls above, buy puts below.
Let's say we went long SP0H at the close today, at about 1393. You
could sell the 1415 Mar call (22pts OTM) for 23 and buy the 1365 put
(28pts OTM) for 23 1/4. (Or maybe you could sell more calls,
farther OTM, to make the option position a net gain. I think Ben
does that. But I'm not quite sure what happens when you unwind it
and you're only partially covered.) You could design your system for
a 20pt profit target. (Or would it be better to roll up to higher
calls if the market goes your way?) Then you could use e.g. an 8pt
MM stop, and just use the options for disaster insurance. In other
words you wouldn't use the put as your "stop" because you have to buy
it too far away, and your risk:reward ratio is too bad unless you
have a very high win rate.
If the mkt goes up more than 20pts, your call gets called away, so
you're out of your SP position. And I imagine you sell back the put -
- don't know how much it would be worth, but a 1345 put (20pts more
OTM than the 1365, approximating what would happen if SP0H went up
20pts) is going for about 16 or so right now. But you'd also have to
buy back the call (right?), and ATM calls cost about 36 right now --
so that just ate up a huge chunk of your profit, didn't it?? (I
*think* you need 2 puts & calls to balance 1 SP, so you sold the puts
for 2*$1600 and bought the calls for 2*$3600, a net loss of $4000.
Your 20pt SP gain was $5000 -- the buyback cost you 80% of profits!?)
If the mkt goes down, you exit at your MM stop. If the market REALLY
melts down, you're protected by the put. In fact I suspect your put
will be worth more (due to the increased volatility) than the SP
loses, so you might even reduce your losses below the put's 28pt OTM
distance.
If this works the way I think it does, then the changes in the put
and call (including the time decay?) should just about exactly cancel
out. (But that's not what happened in the example above, so
obviously I'm confused somewhere.) If so, then I *think* that if you
did the 22pt call / 28pt put example above, you could exit the SP
trade with a 10pt profit and you should come out just about even on
the options. Correct?
It would be a pain to execute, and I don't know what the slippage
would be like, and I don't know if it's even *possible* in any kind
of size. These options give a whole new meaning to the word
"illiquid." But if it works the way I think it's supposed to work,
that would *completely* protect you against disaster. Which would
allow you to ratchet up your leverage a lot higher without increasing
your exposure to a four-sigma event.
Sound reasonable? If it really does work this way, and if it works
in size, then there must be a lot of pros out there doing it. But
even if it doesn't work with large positions, it might be helpful for
us small fry, if we can just understand it...
Any comments, corrections, or suggestions appreciated!!
Gary
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