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Buying Protection

With the Greek elections on Sunday, it does not seem like a bad idea to take a few chips off of the table.   You could sell out of your long positions and create tax issues or you could look at an overlay hedge with options.  The simplest method for protection is to figure out how long you want to protect for and buy a simple put on the S&P 500.  The problem with this method is that it is pretty expensive:


There are two items that you can note on this chart of implied volatility skew – the first is that near dated ATM options are cheaper than longer dated options.  The second is that out of the money options are significantly more expensive (steeper line) than ATM options.  This skew is more steep in shorter dated space and flatter in the longer dated space.  This means that if you are looking to buy shorter dated protection, you can sell out of the money options to cheapen the cost of that hedge.  If we focus strictly on December 2012 options, we can reduce our hedge cost significantly if we are willing to only protect the next 10% downdraft:

Your cost of protection goes from 7% to 3.1%, but then you are only protecting against a 10% downdraft.  If you are willing to take your upside out by selling a 10% out of the money call, then you can further reduce your protection cost to 1.6%.  Further creativity can reduce the cost significantly (or make it a net credit) by introducing put ratio spreads or calendar spreads.

Posted in Derivatives, Economics, Markets.

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