Early in the spring of 2009, gloom and doom ruled the financial markets. Equities had cratered. We were all hearing a lot about terrible problems caused by exotic derivatives such as credit default swaps (CDS). Those swaps had originally been intended to protect the holders of corporate stock or bonds from losses, but the CDS market had acquired a bad name in March, 2009. According to a paper published by the CBOE, some of the issues with the CDS market were "counterparty issues, lack of transparency, insufficient collateral requirements and inefficient trade processing" (DOOM Quick Reference Guide, March, 2009).
However, anyone who had lived and traded through 1987 and subsequent terrible downdrafts, and even those of us who traded through only some of those periods can well understand the desire for downside protection. A lot of people have discussed using long VIX options for this purpose--a tactic that is probably fraught with about as many perils as the CDS market, it turns out. I know of some traders or investors who regularly pick up cheap out-of-the-money puts on any rally to hedge against downside risk. I've personally advocated that those who have long equity positions that they can't or won't sell at predetermined account-appropriate stops educate themselves about collaring techniques and talk to their brokers or advisers about their use.
The CBOE suggests another technique. In a white paper published in March, 2009, the CBOE proposed another method that some traders might consider to hedge against losses in their equity positions. Since the examples outlined in the D.O.O.M method mention spending $66,000 or so on downside insurance, the white paper clearly targets an audience of institutional or wealthy equity owners. I'm not a buy-and-hold type person, but if I were, I'd probably be thinking more in terms of $66 or $660 on insurance, depending on the position being hedged, rather than $66,000! Most of us wouldn't need $66,000 in insurance for our positions anyway, but perhaps some of us might find the strategy employed a useful one.
The white paper compares the performance of an equivalent sum spent on a CDS on Lehman versus the purchase of a LEH 25/15 put spread initiated by buying a 25-strike put and selling a 15-strike one. As Lehman failed, the CDS outperformed, but by only a small amount. Since my mother-in-law lost what was to her a hefty amount due to Lehman corporate bonds she held, the information caught my attention. Another comparison was made of a Visteon CDS versus the simple purchase of an equivalent amount spent on 2.5 strike puts. These Deep-Out-Of-the-Money puts led to the name for the options, DOOM options. Clever, right?
Quoting from a 2007 paper by Dr. Peter Carr, Head of Quantitative Financial Research at Bloomberg, the CBOE's white paper pointed to one reason that all of us might profit from watching such deep OTM put spreads, whether or not we intend to use them for protection in our own portfolios: as the threat of default grows, the CDS and the put spread behaved almost identically. In other words, the put spreads can indicate problems in an underlying, sometimes sooner than the CDS would, the research concluded.
How does the put spread indicate problems? It rises in value. However, when I studied the charts provided, it seemed to me that the put spreads rose in value as Lehman's price dropped, as should be expected for a put debit spread. While the rise in price certainly was of benefit to those seeking to protect their equity investment, the charts provided did not, in my opinion, ably demonstrate any predictive quality. So, while I might not yet be persuaded to watch these for a prediction of credit default risk, I might consider educating myself further about the employment of debit spreads in deep-out-of-the-money puts to hedge equity risk.
The CBOE wants investors to know that the put spreads have many advantages over CDS's when used for this purpose. The Options Clearing Corporation clears options, the market for options is completely transparent, and options can be traded in a regular securities account without the need for some of the documentation necessary before trading in the CDS market. So, transparency and liquidity are two of the possible benefits.
The 2009 white paper linked above went further than a simple discussion of the relative merits of CDS and deep-out-of-the-money put spreads. It listed companies on which DOOMs might be used. Check it out if you're interested and then discuss it with your broker or financial adviser. My Trader's Corner article this week will also be a companion to this one, showing how DOOM options might perform under certain conditions. As I mention in that article, I've never used DOOM options in this manner and am not suggesting a particular trade. However, I know that many subscribers join me in looking for methods to hedge against an adverse market event. I mention this as a possible avenue of research only.