Most traders are always on the lookout for ways of being able to protect their portfolios. You may have existing stocks which you wish to protect, or you might be an options trader, and you need to be able to protect your trades from a Black Swan event.
We should start by trying to define what a Black Swan event is. Unfortunately there is no specific definition which is widely accepted by traders. I'll therefore give you my main criteria for a Black Swan event, and that is:
a) a drop of 10% or more of the underlying, over no more than a few days
b) a significant spike in IV, by more than 50%
Although there are multiple strategies which can be implemented in order to hedge against a Black Swan event, one of the most popular is the use of “units” or “teenies”. A teenie is the purchase of an out-of-the-money (OTM) long put. Traders will commonly purchase teenies which are worth approximately $2 of option premium or less, and they will use an expiration ranging from 30 days out to 90 days out.
In the Portfolio Margin and SPAN Margin Trading Tactics (PMTT) course, we use a trade called the Black Swan Hedge (BSH) in order to protect our trades from Black Swan events. A very common question which comes up is how the BSH compares to the use of teenies. I tell people that the BSH typically provides around twice the hedging power of teenies for the same starting cost, but (rightfully so) traders want to see it with their own eyes. I've hesitated doing this in the past, since I want to protect the intellectual property of the trade setup and management, which are fully covered in the paid course.
In this blog post, we'll show how the BSH compares to the use of teenies for the Aug 24, 2015 crash. The expiration graph and matrix for the BSH will be hidden, but you'll be able to see the T+0, profit and loss, and greeks.
Trade setup on Aug 12, 2015
Let's start by setting up both a BSH and some teenies on Aug 12, 2015. We will spend roughly $280 on each, so that we can do a fair comparison. We will also use the same expiration cycle (65 DTE) for both trades.
If you look at the T+0 comparison on the right hand side, you'll see that the BSH has more “lift power” than the teenies. Note also in the greek comparison on the bottom that the BSH has positive vega of 149 versus the teenies which have positive vega of 94. We want our downside hedges to have as much positive vega as possible. The last thing to note on the bottom left is confirming that we are spending the same amount of money on both hedges (BSH and teenies).
Aug 24, 2015
Let's start by seeing what happened on during the Aug 24, 2015 crash:
You can see that SPX dropped 236 points (11.24%) in 5 days, and VIX increased 40 points (309%) during that same time. This is exactly the type of event we are looking to protect against.
Results on Aug 24, 2015
Let's have a look at how the teenies performed on Aug 24:
We purchased the teenies for $275 on Aug 12 and they are now worth $4785 !
They performed fantastically well.
Now let's take a look at how the Black Swan Hedge (BSH) trade performed:
We purchased the BSH for $280 on Aug 12, and it's now worth $8410 !
So you can see that the BSH gave us nearly twice as much profit during the crash as what we could get from teenies, and for the exact same starting cost.
What does a real portfolio look like with this kind of protection?
I'm writing this blog post on Sat, Sep 2, 2017.
I think the most fair way of showing what a real portfolio can potentially look like is to show you my current trades, as of today. Here you can see that I'm selecting all of my trades and combining them onto a single risk graph:
Here is what my combined portfolio risk graph looks like, as of today:
Would you feel worried about a market crash if you had a T+0 that looked like this?
Crashes are rare
By definition, black swan events are very rare. This means that the majority of the time, the money you spend on your pro-active portfolio protection is going to be money you kiss goodbye. It's the same as life / car / home / health insurance, where you pay the monthly premium just in case something bad happens, but most of the time everything will be fine and the monthly premium you pay is money you kiss goodbye.
Does this imply that you therefore should NOT buy any kind of life / car / home / health insurance, since the likelihood of you needing it is rare? Of course not. Pro-active protection is always a good idea, and that includes getting pro-active insurance for your stock or trading portfolio.
Some people recommend that you shouldn't “waste money” on portfolio protection, and you should just have an expectation that perhaps once a decade your account will get wiped out. You should therefore only allocate 20% or so of your total net worth into your trading account, so that when you do get wiped out you then have sufficient funds to re-seed your trading account and start over. Let's say that you have a $200K trading account. If that's going to be 20% of your net worth, then you'll need a net worth of $200K / 20% = $1 million. That extra $800K that you theoretically have cannot be used for trading, since you have to be able to withstand your entire account getting wiped out. I don't know about you, but I find that unacceptable. Most people won't have a liquid net worth of $1 million and even if you did, then you would likely want to have the “extra” $800K working for you rather than just sitting in a bank.
Therefore if you aren't willing to have your entire account wiped out by a Black Swan event, as rare as they may be, then you'll need to spend money on “buying insurance” (hedging) for your stock or options portfolio. You can definitely use teenies, but if you want twice the amount of protection for the same cost, then that's where you can learn the Black Swan Hedge trade, which is part of the PMTT course.
The course also teaches multiple strategies in order to finance the initial cost of the BSHs, as well as a very simple technical analysis system which can help you with timing entry/exit into financing legs for the BSHs.