hedging risk with net credit spreads

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phoenix
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hedging risk with net credit spreads

Post by phoenix » 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.

Ted Annemann
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Post by Ted Annemann » Fri May 21, 2004 9:04 pm

I've studied and rejected the idea. I trade "thin" futures markets like Muni Bond and the FINEX cross-rate futures and Lumber and the Russell. (So I'm not competing against the John Henrys and the Bill Dunns of the multi billion dollar CTA world.) Options are either nonexistant or the bid-ask spread will kill you in these markets.

Another downside is, to get the same net "delta" (dollars of profit into your pocket, for each point or market movement) with the option hedge, you'll need to trade larger number of futures (and thus larger numbers of options). For example, the pure futures play might be to short 5 contracts of Dollar Index futures. With the hedge, you'd need to short 8 futures contracts AND sell 8 calls AND buy 8 calls, to have the same net delta. 5 commissions versus 24 commissions. No thank you.

phoenix
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Post by phoenix » Fri May 21, 2004 9:24 pm

Ted Annemann wrote:I've studied and rejected the idea. I trade "thin" futures markets like Muni Bond and the FINEX cross-rate futures and Lumber and the Russell. (So I'm not competing against the John Henrys and the Bill Dunns of the multi billion dollar CTA world.) Options are either nonexistant or the bid-ask spread will kill you in these markets.

Another downside is, to get the same net "delta" (dollars of profit into your pocket, for each point or market movement) with the option hedge, you'll need to trade larger number of futures (and thus larger numbers of options). For example, the pure futures play might be to short 5 contracts of Dollar Index futures. With the hedge, you'd need to short 8 futures contracts AND sell 8 calls AND buy 8 calls, to have the same net delta. 5 commissions versus 24 commissions. No thank you.

I agree it's a no-go in thin markets... and the extra commissions and slippage are definitely a negative, probably the biggest - but couldn't a larger position size for the futures, without a commensurate increase in risk over a series of trades thanks to the option hedge, be seen as a good thing? i.e. wouldn't your rare monster winners be proportionally bigger for starting with a larger contract base?

Say that the strategy was net break even or a tad negative - the extra commission and slip canceling out the larger percentage gains on winning futures trades and the credit spread gains in flat / reversing markets.

Couldn't the equity curve smoothing still be potentially worth it, if you had a hedge strategy that saved your bacon in long periods of chop while still offering open ended exposure? It could even be argued that your total % gain could be higher over time, even if your winning periods were buffered a bit, b/c you would have lesser drawdown periods to recover from.

It may be that commission and slippage is enough to invalidate the theory - not sure of that though.

p.s. I assume you meant puts in your example, as you would want to be short volatility against the same direction of the futures, rather than putting on a debit spread in the other direction and being long volatility twice :o

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