I have a substantial position in one small-cap stock. This stock has stock options but they are thinly traded such that the spread is wide. I think a correction is imminent. I came up with four ways to deal with this. I can hedge the whole thing by: 1) sell stock and buy calls 2) buy puts Or only hedge the beta by (option spread is small) 3) sell stock and buy qqqq calls 4) buy qqqq puts Suppose I have 1000 shares, which approach should I use to hedge? Suppose I know the beta, how many calls/puts do I need to buy to hedge the beta? Thanks in advance for your input.
Why does this sound like a HW question.
You can treat it as an HW question. 
How wide are the spreads, would you have any shot at a zero-cost collar? I’d be reluctant to rely on Beta too much…
beta doesnt matter when hedging with options. you need to look at the option delta on whatever strike you want to hedge to figure out how many contracts to sell # of contracts * 100 * market price * delta
ahahah Wrote: ------------------------------------------------------- > How wide are the spreads, would you have any shot > at a zero-cost collar? I’d be reluctant to rely > on Beta too much… The spread is about 13% of the mid point of bid and ask I plan to use my Roth IRA to buy the options. I can’t short with my IRA, so I can’t do collar.
sell the stock?
Any negative ETF plays?
ConvertArb Wrote: ------------------------------------------------------- > sell the stock? Agree if you can’t collar.
hausm49008 Wrote: ------------------------------------------------------- > beta doesnt matter when hedging with options. you > need to look at the option delta on whatever > strike you want to hedge to figure out how many > contracts to sell > > # of contracts * 100 * market price * delta Read the chapter on gamma before offering this advice…
^agree. You don’t delta hedge if you’re writing covered calls. Example of someone learning too much from a textbook and applying it the wrong way.
If there are a lot of strike prices available, you could possibly buy puts, but spread your purchase over a variety of strike prices and expirations. That could minimize market impact.
4, buy the mkt puts, and the number you buy will be determined by the beta of the stock (there’s a calculation)
young_professional Wrote: ------------------------------------------------------- > 4, buy the mkt puts, and the number you buy will > be determined by the beta of the stock (there’s a > calculation) I am also leaning toward using the market options. Other than the lower spread, it also fit my personal market expectation better because I am thinking about a general market correction. But what is the formula? For futures, it can be -(beta*stock_price)/(beta_of_futures*futures_price) What is the one for options?
young_professional Wrote: ------------------------------------------------------- > 4, buy the mkt puts, and the number you buy will > be determined by the beta of the stock (there’s a > calculation) He used the term “market correction.” I’m assuming he is heading some sort of company specific event or price movement not explained by market changes. Beta hedging is intended for systematic risk.
If someone has more relevent experience, please chime in and call me an a$$hole, but I’ve found that hedge ratios that come from Beta estimates are fairly ineffective outside of the realm of the CFA exams. Especially over the short run. Anyone else have any luck using Beta to actually hedge systematic risk in practice? I think Beta is a good portfolio indicator, but a bad hedge ratio.
I don’t know from experience, but I do think a long term beta is not so good for a short term hedge. Also, since part of beta comes from relative volatilities (this one wiggles a lot more than the market, or a lot less, etc.) and part of beta comes from correlation (these move consistently in the same direction, or not), a hedge with beta will work better when the correlation is high and not if the correlation is low (it’s obvious when you hear it, but lots of people don’t think about this). Another option is to use beta estimated from just recent data. That’s fine if you think the conditions that established it change. So what you really want to do is some kind of calculation that balances the non-market risk that you get by using a market option (that would be something like sqrt((1-corr^2)*SD(stock)^2) ) with the difference in the bid-ask spread of the market option vs the stock-specific option. It should be doable, but I can’t really figure it out in my head, since I’m not really an option guy.
My analysis of the four choices: 1) This simply turn my portfolio into a principal protected note. I still have the same alpha and beta risk. But the downside is limited because the upside is also smaller. 2) This is a classic put hedge that can hedge away both the alpha and beta risk 3) This is similar to 1) but I give up the alpha. Since I think my alpha will remain positive. This option doesn’t make sense to me. 4) This hedges away the beta risk while keeping the alpha. This might be the closest option to my view, ie the market will go down but the alpha of my stock remains positive. Did I miss something?