Vertical axis is at zero, so if the black line touches
it means the account is entirely
wiped out.
The objective is to keep the yellow
line on the left side of this zero line by using hedging.
This example assumes a correlation of 1 of stocks held
to the FT-SE 100 index.
Hedging is a measure against
market aberration, so this is why the chart shows the losses
that would arise from all degrees of collapse in the Index
We can see that our £
50,000 equity is totally lost with
the index below 3650, and ends at -£
100,000 in the unlikely
event of the index falling to zero.
So, let us now
examine how this curve can be altered to lessen the pain of a
market collapse.
Chart 2 Partially hedged
As the FT-SE 100 in this example is trading
at 5000, which equates to £
30 per point on our £
150,000 net
long position, we can see how the effect
of a market collapse
is lessened by purchasing 4000 series put options. We can
clearly see how the index need to decline to 2650 before our
equity
is wiped, and in the event of total collapse, our debt
to our stockbroker is lessened to -£
40,000.
The cost of
this operation, for option expiry around 4 month to expire is
around 5p x 15 = £
65.
This is not exactly a bank
breaking measure, but neither is it going to be much use in
smaller declines.
In this instance, in addition to the purchase of £
15 per
point of 4000 puts, we will add a further £
10 per point of
4500 puts, but to reduce cost we will
choose an option with
2.5 months to expiry.
So we need to add 7.5p x £
10 =
£
75 to our 5p x 15 = £
65, making the total cost £
140.
This time, we have spent more, and we can see that even if the
index dips to zero, we never lose all of our equity.
In fact
we would still have £
5000 left.
Again this is not an
expensive operation, but we can see it saves us from
bankruptcy.
Chart 4 Partially hedged with 3 strikes
Now we have used the full £
30 per point, and bought a
further £
5 per point of 4900 puts with 2.5 months to expiry
costing us 15p x 5 = £
65, adding
on the £
170 already
spent, we end up with £
235 to cover us from losing more than
£
20,000 of our original £
50,000.
Chart 5 over hedged ( which is the same as being net short
once the price goes below 4000 )
Now, instead of
shelling out £
30 per point on closer to the money puts, we
have bought £
50 per point of 4000 series, 2.5 month to expire
puts.
We can see the worst case scenario is expiry at the
money, (hence expiring with no value) but any moves of greater
decline pay out more than the
losses on the original long
position.
Cost is 5p x 50 = £
250.
Chart 6 over hedged with 3 stage cover
The below chart shows a blend of 3 strikes at 4900, costing 14
x 15p = £
210, 4500 costing 7.5 x 12p = £
90, and 4000 costing 8
x 5p = £
40.
Total cost = £
340. This is very similar to my own
preferred hedge choice. To spend this roughly every 2 months
when I am carrying a net long
position is not a wasted
expense. Even considering if the real probability of a 25%
decline in the index, must be something in the region of a
2000:1
chance, it provides one peace of mind, that no matter
what happens in tomorrow's market one can survive relatively
unscathed, or even profit from
such a surprise.
As it is all too frequent
that undisciplined losing traders actually blame the market
for doing something it was "not supposed to do".........did
anyone
tell the market it was not supposed to crash in 1987?
EVERYTHING THAT GOES WRONG
IN YOUR TRADING IS YOUR FAULT - LEARN TO BE ACCOUNTABLE-
ACCEPT
RESPONSIBILITY FOR YOUR OWN MISTAKES - OR YOU WILL FAIL.
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About
Precision Trading Systems was founded in 2006
providing high quality indicators and trading systems for a wide range of
markets and levels of experience.
Supporting NinjaTrader, Tradestation and
MultiCharts.
Admin notes
PPage updated July 8th 2023 from
original creation in 2010 - New responsive page GA4 added canonical this. 5/5 html baloon
