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if you take the action of buying a put to try to play it both ways you are giving up EV because you cant "win" both trades. If it still goes up and more than covers the cost of the option you may think you have gained, but you really paid a price by giving up some return. If the stock comes down a bit making the option a winner you lose value on the shares you could have captured by just selling earlier.
Except you can indeed win both trades. For example, the equity can have a short-term dip and you sell the puts and profit from them. This nukes your hedge, but suppose the reason for the hedge no longer exists (e.g., the critical event has based) and you keep your position open. Now if it goes up beyond the strike price of the puts you have won on both sides.
Regardless, as I said in my previous post, I have no idea what you mean by "EV". You seem to consider any hedge "a cost" and find no value in the fact that a hedge reduces your downside...so obviously you don't have the standard mathematical notion in mind.
I'm not sure what you mean when you say "EV", but I'm talking about the mathematical concept. The expected value of a trade is based on the probability of its various price movements within your defined time-frame as a result the only way the expected value of the trade wouldn't increase with a hedge is if it had no downside to began with!
I actually think it's a little more nuanced. It's very possible that a hedge can reduce the expected value of a trade because, while it does reduce the downside, it also reduces the upside. And the theoretical concept of "expected value" is going to be a function of both of those outcomes and their respective probabilities.
So it's not necessarily true that a hedge will always increase the expected value of the trade; rather, a hedge will sometimes increase the expected value of a trade, and sometimes decrease the expected value of a trade. In the case of the latter, the investor should ask himself whether the reduction in expected value is worth the protection he receives by initiating the hedge.
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Originally Posted by user_id
So the real question is whether the increase in expected value justifies the cost of the hedge.
I would say that the question is actually whether the costs of the hedge, including both the premium and reduction in upside potential, are worth the reduction in risk.
Perhaps, but that's going to require that you accurately time the market twice -- easier said than done. And for that matter, you could do the same thing by simply selling the position and reopening. In fact, the payoff of doing that would be higher because you wont incur the cost of buying the put.
You're missing the point. There are numerous price paths the underlying equity can take and assuming one and building diagrams around it and pretending it tells you about the payoffs of the strategies in general makes little sense.
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Originally Posted by ML North
..but all these being equal, the sophisticated hedging strategies are rarely cost effective for retail investors holding long equity positions, as I showed above.
Except of course that your diagrams don't show anything about the general picture which you are commenting on....
But hey, if you don't want to use hedges don't use them. I think I explained my position sufficiently.
Strongly disagree. There's not enough liquidity for large institutional holders to liquidate huge positions -- that is, unloading a lot of shares is going to put downward pressure on the stock (because you first wipe out the highest bid, and then the next highest bid, and so on, each time selling for a slightly lower price). It can take days or weeks to unwind a large position, so purchasing options can be very cost-effective if the seller can avoid pushing down the stock price.
Firstly....why are we even talking about institutional holders? That doesn't apply to anybody here. Secondly, your claim about institutional holders is goofy. Though you correctly assert that unloading a large position can effect the market, you completely ignore the fact that hedging a large position will have similar effects (except it will inflate it) to whatever instrument is being used to hedge matters.
So, though they move the market when they try to unload a position they will move the market when they try to hedge as well and the two will largely offset each other, hence the decision as to whether they should hedge the position or not is roughly equivalent to the average investor.
There are numerous price paths the underlying equity can take
The price path is irrelevant, because benefiting from that price path is based solely upon market timing and the likelihood of timing the market correctly is the same whether one is using equities or options. In other words, the benefits one can incur by exploiting price action are not unique to options, as you're suggesting.
Now obviously one can amplify those movements using options, but that's not what we're talking about (also note that doing so would come with increased risk, which would be inconsistent with hedging in the first place).
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Originally Posted by user_id
and assuming one and building diagrams around it and pretending it tells you about the payoffs of the strategies in general makes little sense.
I made no such assumption. For the reasons explained above, we don't care about the price path, which is why it's not considered in the model.
Perhaps it makes little sense to you, but I think quantifying the costs and benefits of a variety of strategies makes perfect sense. As I said above, we only care about where the stock goes, not how it gets there**, and the payoff diagrams are perfectly sufficient for that purpose.
**Because the benefits of exploiting price action are unique to neither options nor equities. The same opportunities can be seized with each type of instrument.
Firstly....why are we even talking about institutional holders? That doesn't apply to anybody here.
Well I said that many hedging strategies are only beneficial for large institutional portfolios. You then asked how a hedge can be beneficial for big portfolios and not small ones, I explained that, and now here we are.
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Originally Posted by user_id
Secondly, your claim about institutional holders is goofy. Though you correctly assert that unloading a large position can effect the market, you completely ignore the fact that hedging a large position will have similar effects (except it will inflate it) to whatever instrument is being used to hedge matters.
There were two factual elements to the paragraph in question. I'm going to break them up.
First, let's make it clear that the explanation I gave for how unloading big positions affects stock prices is entirely accurate.
Second, 1 option controls 100 shares. So an investor hedging with options is going to have to buy comparatively few contracts to offset the underlying position. In fact, perhaps a combination of strategies -- liquidating some of the position and buying some options provides the most cost effective solution. One would have to make that judgement based on how the market responds as those positions are being initiated.
Quote:
Originally Posted by user_id
So, though they move the market when they try to unload a position they will move the market when they try to hedge as well and the two will largely offset each other, hence the decision as to whether they should hedge the position or not is roughly equivalent to the average investor.
There would be absolutely no way of knowing that without actually observing the market. It's going to depend on a bunch of factors including the price action and liquidity of each exchange.
The price path is irrelevant, because benefiting from that price path is based solely upon market timing and the likelihood of timing the market correctly is the same whether one is using equities or options.
And you're again missing the point. Your "payoff diagram" is focused on a particular price path and its just one of many price paths, yet when I bring up a different path that has a different result you're up in arms and claim its irrelevant. The alternative path is just as "valid" as the one you're assuming in your toy analysis. Anyhow, a general analysis of a hedged vs non-hedged strategies will have to consider the entire (or an approximation to such) state space....
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Originally Posted by ML North
I made no such assumption. For the reasons explained above, we don't care about the price path, which is why it's not considered in the model.
Of course you did, your assuming that once a stop-loss is triggered the equity never goes back-up. Your model simply assumes away all the serious issues....and then you proclaim that you've demonstrated something.
Quote:
Originally Posted by ML North
As I said above, we only care about where the stock goes, not how it gets there**, and the payoff diagrams are perfectly sufficient for that purpose.
"How it gets there" ends up rather important when you're comparing stop-losses to puts as the biggest down-side to a stop-loss is it being triggered by a short-term dip.
Anyhow, I'm done with the topic....the mathematics is crystal clear here.
Second, 1 option controls 100 shares. So an investor hedging with options is going to have to buy comparatively few contracts to offset the underlying position.
Dude, is this suppose to be serious? The raw number of things you need to sale is irrelevant, instead its how the size of your position relates to the volume.
If selling N shares of a company can distort the market price, then buying N/100 options will do the same to the option market.
Options are likely to be more efficiently priced on securities such as MSFT and mathematical models/stat geeks are going to manipulate the market in a way that, in general, will exploit the spread and make it harder for individual investors to get a good price. The likely worse spread you are getting, the price of "insurance" and the transaction cost to execute the trade are all "costs" associated with the hedge. Generally speaking, I don't think most individual investors are going to get good deals on hedges like this and without some kind of specific reasoning, are normally better left avoided. That doesn't mean good deals can't be gotten playing options for hedges, it's just that the little guy is likely to get screwed more often than not when the bid/ask spreads are wider.
Institutional investors can "use up" liquidity in the options market and equity markets to get out of (or enter into) a position faster than they can on equity markets alone, because they have the advantage of tapping into two markets to facilitate the action. Sure, lots of trading in equities will impact options and vice versa, but there is still additional liquidity in the options market that can use to supplement a trade on the equity markets.
One advantage of hedging with options over a stop loss is that you can get screwed with a gap down on a stop loss, although with a very stable stock like MSFT a gap down is less of an issue, but if you are playing stop losses with volatile securities, there's also no guarantee that a stop loss will limit your losses at the price you want.
Except you can indeed win both trades. For example, the equity can have a short-term dip and you sell the puts and profit from them. This nukes your hedge, but suppose the reason for the hedge no longer exists (e.g., the critical event has based) and you keep your position open. Now if it goes up beyond the strike price of the puts you have won on both sides.
Regardless, as I said in my previous post, I have no idea what you mean by "EV". You seem to consider any hedge "a cost" and find no value in the fact that a hedge reduces your downside...so obviously you don't have the standard mathematical notion in mind.
Once again I ask why not just sell if you are worried some event comes? EV is a simple distribution of potential outcomes in my view. When I make a trade I dont guess at where it will end up. I take action based on a set of rules, a breakout above a 10 week moving average lets say. I dont shoot for 10% or 20%, I just follow a selling rule. The sale could come after a 2% loss or a 200% gain. Right now I have no idea, just that I have determined I will sell at a certain circumstance, lets say a close at a 20 day low. I entered this trade knowing my trading history suggests I average maybe a 2% gain doing this. That is my EV. If my only trading rule was exactly this, I would expect 2% gain on average for every trade I enter. Where I ********** up is getting to say 5% gain and starting to hedge. A trader, not a hedger must stick to his rules. If a trader gets knocked out of a position by a sudden move so be it, its part of the equation. If a trader should have made 20% on a trade but only makes 12% because he got a little nervous and wanted to lock in some profit with a precautionary put he just damaged his math model. He needed that 20% gain to maintain his 2% EV because baked into his results were an occasional 20% winner. Winning two bets in theory on the same position is not in a good trader's strategy because its not the most efficient way to trade. Traders are better off finding two good entries and winning both. Traders let the market dictate their moves and at times they find gains precisely because those hedging offer opportunities for them.
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