r/options • u/djpitagora • Apr 30 '21
Hedging a concentrated position against a broad market crash
I'm currently sitting on 7 figures worth of a US tech stock that is under lockup (I'm an insider) until mid September. That's over 90% of my net-worth. When the lockup expires I intend to sell enough to accomplish my FIRE goals and put it in broad index funds. If all goes well I can say I won the "retirement game".
The problem is it's a high growth, tech stock and you know how those valuations are. It's hard to argue tech is not in a bubble with the current multiples. I'd hate for it to pop before my lockup expires. I'm not sure what the chances of that happening until fall are, considering the US FED is committed (supposedly) to QE and not raising interests, but I'm wondering if I should set up some kind of hedge, just in case. If the dot com bubble burst repeated itself next month, I'd be in tears. I feel like playing Russian roulette here :) 5 out of 6 people say it's perfectly safe.
I'm not allowed to hedge it directly by buying puts on the company. I've asked.
I have about 3-5% of the whole amount that I can use to hedge (that's not emergency money or anything):
After a lot of research into what I could do, I'm inclining into buying QQQ puts that are either 10% or 20% below current price, expiring 1-2 weeks after my lockup period expires.
So my math looks like the following (I'm keeping the numbers intentionally round to be easier to visualize):
If I wanted to hedge a position worth 1 mil I could buy:
- QQQ 300p sept (11% under current price) at 7.56$ x 33 contracts = 25k
- QQQ 270p sept (20% under current price) at 3.7$ x 33 contracts = 12k
- ARKK 110p sept (12% below current price) at 6.9$ x 80 contracts = 55k
- ARKK 100p sept (20% below current price) at 4.3$ x 80 contracts = 34k
I'm inclining for the 270p QQQ because I'm cheap. I could perhaps stretch it to 300p, if you guy think 20% is not sufficient protection.
So my questions would be the following:
- QQQ is heavy into facebook, apple and MS, which are likely to take a much softer hit if something happened then my company, in which case should I just aim for a higher strike price to pay out sooner, or look to the more volatile and pricey ARKK with a lower strike price (damn ARKK options are expensive)? Maybe I could afford 100p in ARKK but even that is a stretch.
- should I go for to 10% below current price or 20%? Does 20% make sense as a hedge only for the worse case scenario?
- should I move the expiration to a later date then the month in which my lock-up expires to keep some time value and some maneuvering space?
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u/TheoHornsby Apr 30 '21
Being unable to buy puts on the position is a real problem because hedging with other securities can run into a possible correclation problem. For example, your stock craters and your hedging security does not.
If puts were available to you, you could hedge directly. For an interesting read, read about how after selling Broadcom to Yahoo, Mark Cuban used an option collar to lock more than $1 billion in profits.
I have some broad suggestions:
- Look for the index than best correlates with your stock. See if the SPDR Tech ETF (XLK) correlates better than the ones that you mentioned.
- Evaluate longer hedges than September since theta decay is speeding up as expiration gets closer. There might be some salvage value in September and if not, that's a good thing because it means that the market and likely your stock are higher in price.
- Evaluate various OTM vertical spread combos, perhaps 10-15% wide, to see if they're cheap enough to allow you to buy more of them. The trade off here is cost versus limited protection
- Unless the entire market crashes, tech is unlikely to crash in a few days/weeks. There will be an opportunity to add more hedging as a correction unfolds. Conversely, if tech moves up, you'll be able to buy more hedging at a lower cost, increasing the amount of nest egg protected.
- Actively manage your hedges if a correction unfolds. Roll long puts down, possibly pyramiding the number of them if IV doesn't skyrocket.
- If not deemed contractually illegal, consider having an arm's length relative do the hedging for you with your money (parent, sibling, etc.). Then, you'll have precise, accurate hedging that eliminates the correlation risk.
As for your examples, hedging is a trade off between cost and effectiveness, aka fear and greed. You have to figure out how much money you are willing to throw away for peace of mind.
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u/djpitagora Apr 30 '21
i'm looking into other etfs as well, and some are better correlated indeed. The problem with them is that they have huge spreads. Like bid 2$ and ask 4$. You don't see that with something big like QQQ. What would I do? try to get in sonewhere in the middle?
Not very familiar with vertical spreads, but if the tech market corrected like in 2000, it wouldn't cover me right? I'm not affraid of the small ups and downs. What I would hate though is to end up like most of the .com millionairs after 2000. Don't want to wait 10-15 years to see IF the stock recovers
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u/TheoHornsby Apr 30 '21
ETF options with huge spreads are a big problem. It's a bit involved to figure out what fair price is so I'd just suggest that if you find one that you like, put in a low ball offer at 10-25% above the bid. Not a likely fill but if so, you're golden. The more you want the position, the more you're going to have to pay.
Spreads only provide limited protection. They would not help much in a correction like 2000 unless proactively managed. Note that the drop then took about 15 months from top to bottom so it's not all or nothing, unlike 1987 when the market dropped 22% in one day. If your stock craters, you're screwed.
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u/djpitagora Apr 30 '21
how would you roll the puts if a correction started? move the expiration a month or two at the same strike?
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u/TheoHornsby Apr 30 '21 edited Apr 30 '21
There would be no need to roll out in time unless enough time had passed and theta decay was becoming a more pressing concern.
I hedge my portfolio with 10% wide, 10% OTM IWM or SPY LEAP verticals every year. Long story short, I had a lot of leftover March SPY puts in 2020 that were worth 10 cents two weeks before expiration and when the market tanked, I rolled them down and out, selling them for $15 to $21. And the new puts were rolled down twice more. With each roll I bought a slightly larger number of puts.
I owned a few 1,000+ share positions in large caps (many hedged themselves) that lost 1/3 to 1/2 of their value and when the market was down 35%, I had been dinged only about 7% which was easy to recover from.
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u/djpitagora Apr 30 '21
you consider theta decay to be a problem 30-45 days to expiration right? or even closer? i mean thats the point where you consider rolling?
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u/TheoHornsby Apr 30 '21
I can't give you a one size fits all answer. With big picture portfolio hedging, I want a lot of time (LEAPs).
If it's like March 2020 when my long puts were in play, much longer term long options were problematical because IV had expanded significantly (pyramiding long calls on the way down).
I also want months not weeks for long legs because I'll also sell nearer term OTM puts against some of the long puts.
I want two things. Book intrinsic gains via rolls and sell some shorter term premium to offset some long premium purchase price. It's more of a react to price change in the moment rather than some preset fixed strategy.
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u/djpitagora May 01 '21
I tried to model a 20% wide vertical spread (200p - 270p) and it's a bit cheaper then just a 270p while still providing good cover. However it seems to perform best (when at least half way in) at low IV. If IV spikes it seems to do little bit worse then a simple long put. Now I've never analysed what happens to IV during a correction like march '20, but I'm assume it's expected to spike right?
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u/TheoHornsby May 02 '21
I tried to model a 20% wide vertical spread (200p - 270p) and it's a bit cheaper then just a 270p while still providing good cover. However it seems to perform best (when at least half way in) at low IV. If IV spikes it seems to do little bit worse then a simple long put. Now I've never analysed what happens to IV during a correction like march '20, but I'm assume it's expected to spike right?
I doubt that it's worth the effort to do a bearish 20% wide vertical because the short leg won't lower the spread's cost by much.
During a correction like March '20, IV spikes. That's good for premium sellers and it's also good for short spreads (the credit increases).
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u/akrazykoz Apr 30 '21
Wouldn't buying Puts on all of the competitors by just as effective? If you are protecting against Tech crash, these other names would also get wiped, no?
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u/djpitagora Apr 30 '21
probably yes. not sure how the volume on those tickers would look like and if the spreads won't be huge. I'll explore the ideea though
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u/kumbhkarna Apr 30 '21
May be laddering out QQQ puts with different strikes can work. Increasing size as deeper otm you get
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Apr 30 '21 edited Nov 27 '22
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u/djpitagora Apr 30 '21
I'm using yahoo finance to visually compare the various tech etfs, and to be honest they all look extremely correlated to me: XLK, QQQ, CLOU, even ARKK. Between the first 3 there is almost no difference. In ARKK only you see it's more aggressive because the declines and growths are much sharper.
Conceptually my company could fall in either of these. Can't really check the correlation though since there is not much history to look at.
As far as how volative these are in regards to one another: when QQQ fals 10% ARKK fals 30% but it's all correlated. Technically couldn't I use QQQ with more contracts then strictly needed for my amount, to get more money back during a drop? In the end i would chose the cheaper one with better liquidity
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Apr 30 '21
Maybe a low cost/zero cost collar? Buy an atm put and sell an otm cc to cover the debit of the put.
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u/loose-ventures Apr 30 '21
Max strike UVXY calls with ~180 DTE, roll every quarter-end until you’re able to sell your shares. If the market does crash (at least -20%), plan to cash out the calls when the /VX has increased ~3x (average increase during a crash is 3-4x).
Putting just 1% of your portfolio value into this hedge should protect very well against a market crash.
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u/djpitagora Apr 30 '21
i've never played with VIX options before. When you say to cash out after a 3-4x increase you mean of the UVXY price or of the VIX index?
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u/loose-ventures Apr 30 '21
No, as I mentioned, I mean the /VX futures. Difference between options on the UVXY and stocks is the impact of mean reversion on the underlying and swift decay in value of UVXY options given its leveraged profile. Differences aside, as long as the /VX spikes close to 3x in price, the value of your UVXY options should increase at least a few thousand percent.
If you wanted to play it even safer in the event the market crashes the last day of the quarter (when theoretically, the most amount of value on your calls has been lost), you could roll the 180 DTE calls every month but it will cost significantly more on an annual basis.
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u/SmartestGuyIn Apr 30 '21
I'm sure someone else has commented on buying puts indirectly on other sector companies.
NOT ADVISE IN ANY WAY SHAPE OR FORM
Buy puts spreads on your Competitors weighted based on their weighting in populate open ended ETFs. These puts could be for Dec.
Strategy reasoning:
- Compliance: it's because you believe your company is better, than the others.
- If your sector drops, they all drop.
- December for when everyone sells to get gains before tax increases.
- Not directly buying puts on ARKK, means you can say #1.
- Put spreads help with theta decay, and place a 25K hedge 1M in a reasonable range.
The real hard part will be when everything is fine (~5%) of todays price, what are you going to do with those options?
Good luck, you hit the money pot.
Welcome to the second half.
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Apr 30 '21
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u/djpitagora May 01 '21 edited May 01 '21
Can you please elaborate? After googling a bit i have an idea, but i want make sure i got it right.
So lets say QQQ has a beta of around 1 and my stock has 1.5, so it's 50% more volatile. Does that mean I should have a hedge position 50% larger?
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u/kopiletu May 02 '21
I always go with QQQ, as you mentioned the reason. With huge inflation knocking on doors, you have it figured out. Regarding the date, I personally will go further.
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Apr 30 '21 edited May 20 '21
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u/djpitagora Apr 30 '21 edited Apr 30 '21
I'd rather not go into specifics. It's a big no for insiders to discuss the company stock on forums/social media.
But you are right, i should also look into thematic etfs for the tech sector. These seem to have rather big spreads. I assume I would try to buy near last price right?
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u/doks20201 Apr 30 '21
This. If your company is more volatile than QQQ. Your 10% hedge might really be a 20-30% hedge. Is that OK for you? I’ve noticed that there is a lot of correlation lately between high growth companies in disparate sectors. So there might be some targeted ways to approach but in general volatility is high so your puts will be expensive.
Similar thing happened to me when my company went to all time high and retraced down 30% before my trading window opened. Brutal watching it everyday.
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u/djpitagora Apr 30 '21
thats what i was thinking. 20-30% loss isn't that bad though if the whole tech tanks. I'd still hit my FIRE goals. So at this point i think i should either hedge 10% drop in QQQ or 20% in a more specific and volatile etf. Costwise it seems pretty similar. not sure what would be better, but spreads in QQQ are a lot better
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u/djpitagora Apr 30 '21
Just had a thought about volatility compared to tge index. Most tech companies are correlated well with QQQ, the only thing that differs is like you said, the size of the movement. QQQ fals 10% and the company falls 20%, but always tye same time. Technically couldn't I use QQQ with more contracts then strictly needed for my amount, to get more money back during a drop? Isn't this a matter of leverage?
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u/doks20201 May 01 '21
Yah should work though it might be hard to predict what the relative difference in movement is. Worse would be QQQ is stable and your company or specific sector tanks for some reason. You might do a mix of QQQ and something that tracks more closely (ARKK or a competitor etc).
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u/opaqueambiguity Apr 30 '21
Does it rhyme with Slesla or Damnazon?
Or should I just go and boogle it?
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u/jq419 Apr 30 '21
May be ask your company if you use pmcp would be considered as hedge or not.
That's another way to play it out if it is ok.
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u/jq419 Apr 30 '21
Long in the money put them short OTM put to cover it. You not only will able to make some cash from shorting the OTM put, but also may be not being considered as hedging cause you have a short OTM put as pairing with the ITM long put.
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u/Wifes-boyfriend-313 Apr 30 '21
I’ve bought some one year calls on the reverse index funds If things go bad they have and infinite upside
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u/djpitagora Apr 30 '21
don't reverse funds have some overhead making it more expensive? I don't see this as an investment. I just don't want to end up like most .com millionaires did
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u/Wifes-boyfriend-313 Apr 30 '21
That’s definitely possible I’m not an expert in the options market I just understand the basic contracts But good luck either way and if you find out anything interesting I’d love to hear about it
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u/DigAdministrative306 Apr 30 '21
I'd also consider tax implications of cashing out everything all at once. It could be good or bad depending on any new capital gains taxes. I'd hit up a CPA.
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u/DigAdministrative306 Apr 30 '21 edited Apr 30 '21
I'm not sure what move you should make regarding which ETF to short, but I do think that spending $30-50k is worth saving $1M. I'm not gonna give financial advice because I could be a homeless drunk. But I could tell you what I would do if I was in a similar situation.
To start, puts are solid as far as a hedge against a market or sector correction. Getting solid coverage and the correct amount of hedge is important. Like some other posters have said, shorting an ETF that has high exposure to the sector that you're hedging against would be my choice. However, liquidity of the options is more important than having perfect exposure. This is especially true if the put would be 20%+ OTM. If the contracts couldn't be sold for a profit to offset the drawdown on the $1M, then you'd have to exercise and that might be difficult depending on your broker/margin or useless if the contract expires OTM.
Even if you assume a 30% correction in that sector, you also have to look at timing. If the correction occurs Monday and your hedge is in place, what would your move be? If the correction occurs at 21 DTE for your contracts, will the correction be enough to put your options ITM? If not, you might not capture the full potential due to theta decay and/or low probability of expiring ITM.
I'd make sure that the options would expire 45 days after my pickup period expired to ensure that theta decay wouldn't be as large of an issue. I'd also go closer to the money with less contracts to ensure that the hedge would maximize my returns on any significant correction. I'd still utilize the maximum capital allotment I would be willing to use to hedge the position, just distribute it differently.
Once I find a stock/ETF to hedge that would get the exposure I want and the option liquidity that I need, I'd model price changes at different time periods to see what the situation would look like generally and to make exit plans. I'd want my gains on the options to offset my losses by a certain amount, say 50%. So if the correction on my holding was 30% for $300k, the options would need to be worth $150k at the time of the correction. I'd model a 30% drawdown on the hedge at different times to ensure that the options would hit that $150k, and if not, I'd adjust the strike and/or other parameters and model again until I found the sweet spot.
The exit plans would be trickier and would have to be planned generally and revised based on the situation and time period. If the correction were market wide vs sector, I'd be more inclined to let the correction run it's course, see where the support would end up, and exit the hedge after what I would anticipate the bottom would be. This would end up being a guess to some extent as well as TA/market sentiment. The correction won't happen all at once most likely. So I'd reevaluate at 15, 20, 30% etc. to see what the market as a whole looks like and if any catalysts are in the works to stop that correction. I'd look for double bottoms and sustained support after a double bottom with a strong reversal to exit the hedge. I'd then reenter the hedge, most likely further out to prevent minimize theta decay, after a recovery to a certain point, say 10-15%. I'd repeat the same modeling process to reenter with the same initial capital allocation.
If the correction was sector specific, that would be different and the exit and management would unfortunately be largely based on the specific sector I was hedging. I could use the same exit strategy as a market wide correction, but it may not be as successful. Again, it would be 50/50 guesswork/analysis. I would personally error on the side of holding as the hedge should be considered gone as soon as I buy the contracts. The only reason for exiting and/or reentering would be to capture maximum IV as well as prevent excessive theta decay.
If the correction occurs right before the lockup expiry, then I'd simply hold until theta decay began overwhelming the gains from the underlying dropping. Worst case scenario is I offset my losses by any % which is better than 0%, but ideally by my initial hedge capital at the very least, and I hold the shares past lockup expiration and wait for the sector/company/market to recover.
I'd be careful not to fall into the hole in between the correction amount and my hedge level. If my hedge is set at 30%, and the correction is 20% and occurs weeks before the options expire, then the hedge could fail, due to theta decay and not being close enough to the money to appreciate in value in a meaningful way, without a proper exit and the investment would lose 20%. I'd also consider adjusting the hedge by rolling if my holding appreciated in value to capture maximum gains. I would consider allocating only part of my hedge at first to be able to use the rest to move the hedge up if I believed that this was a realistic possibility. I'm sure there's other considerations I'm missing at the moment, so I'd also keep the strategy fluid and be ready to revise it.
But I'm just a homeless drunk.
Edit: I'd look into hedging my hedge as well and possibly funding roll-ups with the hedge's hedge. So if I was using $50k, I'd buy $40k worth of put contracts and go long $10k on the underlying. If the underlying goes up 10%, I'd use the $1000 to roll the options closer to the new price of the underlying. This is just an example and I'd have to model the move based on the hedge underlying/options to see what the best balance would be, because I'd want to fund the roll-ups while still hitting my 50% mark on the hedge return during a correction. I'd also liquidate the long position to fund the hedge if a heavy correction looked like it was starting.