The Purpose of a Hedge

Good Morning!

This is the Jumping Cholla (CHOY-uh). The newsletter that turns options market insights into a fun, easy-to-read email that helps you reduce your chances of getting pricked while trading!

Quote of the day:

"A hedge is a tool that allows us to invest without taking excessive risk"

I'm not telling you to "pump the brakes", but if you think you're taking too much risk, there's a simple solution...put on an offsetting bet that lets you sleep for a few nights!!

That's the beauty of "excessive risk", it's in the eye of the beer holder!

Today we are going to learn how to determine and size a portfolio hedge using SPX options.

Each day this week, we'll highlight a specific use case of SPX from the very classy portfolio hedging to the full-blown degeneracy of 0DTE options!

BANG for Your Buck:

Remember, this is where option bookmakers are pricing potential underlying movement for today and for the rest of the week. For day trading, use the daily BANG to estimate the trading range for the day and act accordingly. Here's an example of how to do that (for you teacher's pets, yesterday's turnaround at the BANG was a picture-perfect trading session)

In the coming week, this section will be beefed up with even more relevant and actionable data such as: weekly bang review, overnight expectations, gap probability analysis, and more! Believe it or not, the market just kinda tells you all this stuff, if you know where to look...

What is a Hedge?

A hedge is a group of plants that is used to form a living fence or boundary.

Hedges are typically planted in a row and trained to grow into a dense, solid mass of foliage that serves as a natural barrier or screen. Hedges can be used for a variety of purposes, including providing privacy, noise reduction, marking property lines, etc. 

Hedges are typically evergreen, which means they retain their leaves throughout the year, or they may be deciduous, which means they lose their leaves in the fall.

I'm literally talking about bushes...everything in trading relates to nature!

Hedge bushes and investment hedges are both used to provide protection or to reduce risk.  Think about it, a nice row of boxwoods:

1. looks classy (what did I say about portfolio hedging, right?!)

2. actually protects the estate (core portfolio) from looky-loos, some elements like wind, reduces noise, etc.

Now, this foliage will not protect your house from a drunk driver drifting across your front lawn at 60mph...BUT, it will slow him down, and hell, it might actually wake him up, so he doesn't plow through your living room!

The same goes for a financial hedge to your core assets: it's there to slightly protect your immobile core assets for a limited amount of time. The hedge may be deciduous (that's twice now!) and lose an aspect of its protection e.g., less privacy and more noise after losing its leaves. 

Hedges are living. They must be tended to, pruned, watered, shaped... and if they aren't they will go away and leave you exposed!

Say you want to make a wall around your house instead, to protect it even more?

Well, that requires more planning, construction, and costs a sh**load more than planting a few bushes. And at some point, the wall would be as permanent as your core estate. So, what are we really protecting? Do we need another wall to protect the wall?!

In trading, it's all about achieving a desired level of stability and security, for a limited amount of cost!

Make Me a Better Trader

Scenario: SPX ref= 3900. Portfolio = $400k equivalent exposure to S&P 500

You are worried that the within the next 6 weeks, the Financial Crisis 2: Electric Boogaloo will hit the market!

Not good!

To implement a hedge, we need to answer two questions:

• How much loss are you willing to accept? (do you want a cute little row of boxwoods or 12ft arborvitaes?!)

• How much $$ are you willing to spend? (if you build a wall, it's strong but expensive or if you grow some hedges, it's cheap but protection is limited)

In this scenario:

1. I am willing to accept a 5% loss to my core portfolio. (5k max loss)

2. I'm a cheap bastard, and I want to pay as close to nothing as possible!!

To satisfy my 1st goal, I can buy a put that expires within 6 weeks (Feb 17th expiration) that is 5% OTM (out of the money). 3900 x 95% ~ 3700. 

Okay, so how many puts do I need to buy?

I'm looking to protect 400k of my portfolio. 

Simple math check, market goes to 0 so my core stock portfolio is worth 0 (yikes!) and the put is worth 3700 Put =3700 x 100 (SPX option multiplier) = 370k (this is referred to as notional value of the option)

So, -400k +370k = -30k loss i.e. -30 / 400 ~-7.5% loss...

I only wanted to lose 5%, but screw it, it's good enough for government work!! (One day I'll show you why under hedging is usually fine, if you aren't market timing to a T... hint: extrinsic value)

So, I only need 1 Put, but that Put costs $4400!!!

Dafuq?! This sucks!!!

I don't want to pay for that, but what if I forgo potential gains if the market goes up.

I need to find a Feb 17 2023 Call option that costs roughly the same price as the Put I want.

Let's see what that looks like:

If I SELL the 4040 Call, I can offset my put cost by roughly $4400...

What do I forgo on the upside?

Market is currently at 3900, so 4040 divided by 3900 ~3.5% higher. So, I cannot make more than 3.5% if the market rallies higher than 4040. Pigs and hogs.

For ~6 weeks, my portfolio can only lose ~7.5% no matter what happens, and all I give up are potential gains over 3.5%...not bad.

Now if the boogaloo doesn't happen in 6 weeks and you're still freaking out, you gotta keep pruning your hedges and re-establish! 

As always, pursue the process NOT the profits! See you tomorrow!