Hedging in Options To Cover ur Longs in Cash

[rajesh.sadhanala]

Hi,

I want to discuss few things here. Only related to short term position traders. Not for Intraday, medium term and Long term traders.

We see that now a days market goes in continous uptrends. Is it a better strategy to carry a hedge position of Nifty shorts in options. The main idea is that you do not want to miss out the trend and momentum and at the same time any sudden crash in Nifty will help the short position to cover the portifolio being red. It will help you sometime to decide the trend whether are we on the right side. This is just to make sure that we dont miss the move in Nifty eventhough it is making continous high.

Here we need to balance the longs in cash versus Nifty shorts in options and we need to take right options keeping time frame in mind..
Also your long positions must follow the Nifty movements most of the times.

I just want to know how this strategy works. Any flaws here. Anything we need to take care specially. It also implies vice-versa, I mean Shorts in Futures versus Nifty longs in options.

I know that here they are a large pool of talented people here and I want to gain some knowledge about different strategies.

Till now whatever I am trading is just for testing and learning purposes. From Jan 2008 onwards, it would be an entity for me, a separate part-time business which has accountability. I have to prepare lot of things to start my business from 2008

Regards
Raj

 

[rajesh.sadhanala]

No replies yet.. I think everyone is in the weekend mood.

 

[rajesh.sadhanala]

If u want to invest and cover/headge the position it reduce ur risk but it should not be with long put, selling covered call is the best idea.

How does it differ betwenn the Long put versus Short Call. Can u just elaborate on this. I want to know the intracacies when u compared them.

BTW, I personally feel, (in terms of trading) using s/l is much better than headiging.
F

Definitely you will have S/L in place but we often tend to see the volalitlity to be very high. Also I would not be interested in intraday swings only EOD close. When EOD close is sharp there we see a cut in trendline and we get out but the cut is very sharp so my hedge position can cover it.

Raj

 

[sweetmpv]

HAI, MY SUGGESTION WOULD BE, BUY NIFTY IN CASH, I.e,. BUY NIFTY ETF, GO ON ADDING NIFTY ETF EVERY MONTH WHAT EVER THE PRICE MAY BE, BUY PUT OPTION, SQUARE OF YOUR POSITION IN PUT OPTION WHEN YOU ARE IN GAIN, YOU TRADE FREQUENTLY IN NIFTY PUT OPTION, YOU BE LONG IN NIFTY ETF, NEVER SELL

 

[rajesh.sadhanala]

There are many strategies to hedge your long positions - some strategies are more successful than others based on the market conditions.

Investors / traders think that covered calls provide a strong hedge against downside. As a matter of fact, covered calls will work against you when the stock start to fall.

When the stock starts to fall and as expiration date comes closer, the liquidity in the call vanishes. At the same time you are losing money on the long position. The amount you will lose on the long position will be way more than the amount gained on the call.

Investors / traders who were writing covered during the Nasdaq-era lost huge tons of money when the markets crashed because covered calls did not provide any downside protection.
The disadvantage of a covered call is that profits are limited and will be known upfront but the losses can be unlimited and cannot be predicted till they happen.
Applying stop-losses to covered call positions is a recipe for disaster especially in volatile markets. Your long position will be stopped out and due to lack of liquidity you may have to buy the call back at a higher price or lose money on the call if the market bounces back.
Covered calls work well for mature industries / companies that exhibit low volatility - e.g. Colgate, ITC etc. They are risky for speculative / momentum stocks.

Married puts are slightly better statistically in the long run - but investors shun buying puts because they tend to eat into the profits.
One technique is to buy the married put after the stock has rallied a little bit - so the premium tends to be lower.
The advantage of the married put is that the profits can be unlimited, whereas the losses are restricted / limited and known upfront.
Married puts work better for momentum / breakout stocks. They will eat into your profits for mature, low volatility stocks.

Ahh... cant be better explanation than this.. You have put everything that I have in my mind.

The best thing that you pointed out here is "One technique is to buy the married put after the stock has rallied a little bit - so the premium tends to be lower" otherwise no point having a hedge position.

Raj

 

[rajesh.sadhanala]

In short call ur coverage is limited upto only the amt of premium recd (less brokerage) for example bought nifty future at 5620 sold 5600 call at 116, now premium recd is 5800. If Future goes down by 100 points future would trade at 5520 approx whearas call would be between 40-50 approx.

In long put with a fall of 100 points ur put should be nearly double but practely it doesn' happen.

When fall appear prices dip faster but increase slowly, also there is no gurantee that ur put would move @ .5 or more but in case of short call it is certain that if future prices goes down the call would lose it's value fast.

F

Here we are just following the trend. We dont want to make any money through the call.. A hundred point downwards should not make any huge difference.. unless it is catastrophic fall.

The main objective is to go with the trend and reduce your risks since the market is moving continous upside. Good to see lot of participation coming in. I feel these kind of topics we shud be discussing more

Raj

 

[marcus]

covered calls should be used for long term investments, if you own the stock and have a long term view but are of the opinion there could be a short term correction, but they carry some risk for short term investments.


I think Rajesh's idea is excellent especially in the retail section it is more advantageous to hedge with options than with futures.

Hedging is definitely not perfect whether you use futures or options as faltub pointed out you may incur a small loss or a small profit depending on how well you calculate the beta of your portfolio and in any case there is no necessity the portfolio is going to fluctuate in accordance to your calculation of beta, its only an approximation.

About the point of using s/l instead of hedging this may not be possible neither desireable, it all depends on the size of your portfolio, for eg if you're a money manager or handle the portfolio for HNI's/FI's/FII's etc. its not practical to use stop loss, your stop loss may not even be sold quick enough especially if you use vast number of shares, its not easy to liquidate your position over night, secondly you have to look at it from the taxation and brokerage point of view, if you sell and buy back again, you'll incur more tax liabilities and brokerage.

I think hedgging is preffered than using a s/l, for small individuals use options, buy a put or use the bullish/beraish put/call spread technique if you have a preconceived notion of how low or high the market will go, but it makes more sense for large porfolios's to use futures.

Having said all that Larry williams says 90% of options expire worthless, even NSE agress that the majority of options expire worthless (thought they put the figure at some where around 70% for the NSE) this means ------> its mostly the option writers who rake in the money not the buyers.

 

[rajesh.sadhanala]

covered calls should be used for long term investments, if you own the stock and have a long term view but are of the opinion there could be a short term correction, but they carry some risk for short term investments.


I think Rajesh's idea is excellent especially in the retail section it is more advantageous to hedge with options than with futures.

Hedging is definitely not perfect whether you use futures or options as faltub pointed out you may incur a small loss or a small profit depending on how well you calculate the beta of your portfolio and in any case there is no necessity the portfolio is going to fluctuate in accordance to your calculation of beta, its only an approximation.

About the point of using s/l instead of hedging this may not be possible neither desireable, it all depends on the size of your portfolio, for eg if you're a money manager or handle the portfolio for HNI's/FI's/FII's etc. its not practical to use stop loss, your stop loss may not even be sold quick enough especially if you use vast number of shares, its not easy to liquidate your position over night, secondly you have to look at it from the taxation and brokerage point of view, if you sell and buy back again, you'll incur more tax liabilities and brokerage.

I think hedgging is preffered than using a s/l, for small individuals use options, buy a put or use the bullish/beraish put/call spread technique if you have a preconceived notion of how low or high the market will go, but it makes more sense for large porfolios's to use futures.

Having said all that Larry williams says 90% of options expire worthless, even NSE agress that the majority of options expire worthless (thought they put the figure at some where around 70% for the NSE) this means ------> its mostly the option writers who rake in the money not the buyers.

Actually I never used it rigourously. Just want to see different variations. Its very true that 90% of options expire worthless but rest 10% can cover more than 90% of expiry.

Thanks for your input Marcus.

Regards
Raj

 

[marcus]

Raj is very correct

Larry McMillan can think whatever or say whatever (so can Larry Williams for that matter) it really dosen't matter.

What does matter is what NSE statistics say.

Why the NSE? Well

The NSE were the one's who spear headed the introductions of derivatives in the Indian markets based on the recommendations of the Gupta committee. Although the BSE started two days earlier (on 9th 2000), they simply did this without proper preparations just to take credit as being the first exchenge in India to start derivatives.

As such it was the NSE who laid all the groundwork and followed the recommendations of the Gupta committee. Its primarily because of the NSE (and of course the change in foreign policy by the govt.) that FII's have entered the Indian markets with confidence, they have given credibility to the Indian markets. NSE gurantees that every single trader who trades through them will receive his money even if they opposite party defaults, they even have a gurantee fund which has now accumulated to the tune of over 2000 crores to pay any creditors in case of default of the opposite party (even though this has nothing to do with NSE).

They've fullfilled their promise all though there have been a few cases of default (you can count them on your fingers they are so few) despite this every credible or desrving trader has got his dues. Even when the markets fell by a recored 18% a few years ago not a single case of default took place. The CME (Chicago mercantile exchange, chicago wale ither attay hai!) was so impressed by this they actually came to the NSE to study their working as to how the NSE managed this.

In short what I'm trying to say you can believe the NSE instead of Mr. McMillan, take my word for it.

Although I do not have the precise figures with me, the NSE derivatives dept actually calculates statistics for all its trades on a regular basis. If you would be so kind as to pm me, I'll give you the number for Mr. Paul who was responsible for the introduction, research, and implementation at the ground level of the derivatives market in India, he left NSE a few months ago and has now joined Bank of America as head of derivatives. He was the person looking after the derivatives section of the NSE and the person under whom most statistics and recommendations were done.

You may also cntact Mr. Mukherjee (can't give you his number coz I don't know him) who is vice president of the NSE and he will confirm this as well.

These are very credible people and I'm sure they will try to furnish any proof you require, I on the other hand know Mr. Paul well and take his word for it.

Thats the proof part

Now coming to the reason lets try to analyse;

There are four MAIN market conditions.

1) Rising market (bullish)
2) Falling market (bearish)
3) Volatile market (moving up and then down)
4) Stagnant market

Lets take the example of a trader who has sold a call option.

1)The market rises and he loses

2)The market falls and he has no loss he actually pockets the premium

3)The market is volatile it moves up and down, he has no loss, he pockets the premium, why? because he will only lose once the the spot price rises beyond the value of the premium, so he has room for an up move , and besides even if it does go a little higher than the premium cover it would go down a bit, which is the nature of volatile markets.

4)The market is stagnant and once again he pockets the premium.


So out of the above four basic market conditions the option writer wins in three out of the four cases, which is a 75% win porobability while the options buyer wins only in one case which is a 25% probability, all other conditions remaining the same as a general case to illustrate the example.