hedging risk with net credit spreads
Posted: Fri May 21, 2004 7:35 pm
Do any of you mechanical (or non-mechanical for that matter) trend followers ever hedge your trade risk with net credit spreads?
It would seem a logical thing to do in terms of "smoothing out the equity curve" while maintaining open ended upside potential.
For example, if you got a signal to go long soybeans, you could pair the position with a vertical bear call spread - a limited risk option position that would gain if the market reversed direction, flattened out or lost volatility - all potential losing scenarios for the trend following trade.
If the trend trade worked, the limited loss on the net credit spread would be made up for, in most cases, by the gain in the futures position. More importantly, the credit spreads would tend to offer positive return during flat / sideways markets, i.e. precisely when trend following methodologies are getting chewed up.
The whipsaw danger - market takes out the futures position, then turns around and threatens the options position again - would be mitigated by the fact that if the market were making a fresh go at your credit spread, it would have to be at new highs / lows and thus signaling you to re-enter.
I was just wondering how often this is done as I haven't really heard of trend followers or mechanical traders using options to hedge out some of their volatility risk (i.e. the risk that volatility will decline and slow markets will gum their account into submission).
If there's a reason why it's not more prevalent as a strategy, or if anyone has tried / tested it and discarded it, I'd be curious to hear why.
It would seem a logical thing to do in terms of "smoothing out the equity curve" while maintaining open ended upside potential.
For example, if you got a signal to go long soybeans, you could pair the position with a vertical bear call spread - a limited risk option position that would gain if the market reversed direction, flattened out or lost volatility - all potential losing scenarios for the trend following trade.
If the trend trade worked, the limited loss on the net credit spread would be made up for, in most cases, by the gain in the futures position. More importantly, the credit spreads would tend to offer positive return during flat / sideways markets, i.e. precisely when trend following methodologies are getting chewed up.
The whipsaw danger - market takes out the futures position, then turns around and threatens the options position again - would be mitigated by the fact that if the market were making a fresh go at your credit spread, it would have to be at new highs / lows and thus signaling you to re-enter.
I was just wondering how often this is done as I haven't really heard of trend followers or mechanical traders using options to hedge out some of their volatility risk (i.e. the risk that volatility will decline and slow markets will gum their account into submission).
If there's a reason why it's not more prevalent as a strategy, or if anyone has tried / tested it and discarded it, I'd be curious to hear why.