September 4 will mark a solemn anniversary in my community. Last year on September 4, wildfires broke out, fueled by the dry gusty winds that were the remains of a tropical storm. By the time those fires had roared through our area and back again for days, a state park and 1600 homes were destroyed and two lives were lost. We're a small community, and those 1600 homes represented a massive loss.
That loss was made worse by the fact that in this small community, not all homeowners bought insurance. This spring, heavy rains washed across drought- and fire-ravaged areas, resulting in flooding in areas where homes had never flooded in recent history. Those areas often weren't in flood plains. Even those who had home insurance most often did not purchase the separate flood insurance. They weren't covered.
What does this have to do with options trading? Many of us can shake our heads at those homeowners who failed to buy homeowners insurance, even if we understand why they wouldn't buy flood insurance. In keeping with my cautious nature and because I'm grew up in at-sea-level Port Arthur, we have flood insurance, too.
No one expects to make a profit on homeowner's insurance. Most of us hope our insurance is never needed. If it is, something bothersome if not downright devastating has occurred.
Why, then, do so many market participants have a reluctance to insure our long-term and short-term portfolios, eschewing any options positions that aren't designed explicitly to make a profit? We don't expect to make a profit on our homeowner's insurance and we still understand the wisdom of buying it, but the concept escapes us when applied to options.
As I've pointed out for years and as your own research into the history of options will tell you, options were invented to provide insurance, not as a trading vehicle. A producer or manufacturer might have wanted to insure against a rise in crop or material prices, for example. After the stock market crash in the late 1980's, those holding equities increasingly wanted to insure against another crash.
Those opposing needs resulted in different options skews for materials-related products such as SLV and equities such AAPL. Manufacturers who needed silver might want to buy futures or calls to insure against a devastating rise in silver products. While it's a bit simplistic to assume that they'd purchase this insurance via SLV calls, the SLV skew chart from a week ago, when this article was roughed out, still illustrates the kind of skews we might see in a commodity-related underlying.
OTM Skew Chart for Four SLV Options Series:
We can see that the chart of implied volatility versus strike price shows implied volatilities kicking up strongly both in the calls above the money and the puts below the money. With SLV being used as a trading vehicle, we may be seeing a higher skew in OTM puts than would have been normal in the past for a materials-related entity.
Contrast this to the shape of the chart on an equity such as AAPL.
OTM Skew for Four Series for AAPL:
Obviously, the skew is different on this equity when compared to a material-related entity such as SLV. There's extra demand for OTM puts, beefing up the implied volatility in those and making them expensive when compared to calls. This shows off that skew that's been seen in equities since the late 1980's. It points to the first reason--and some would still say, the most valid reason--to be an options trader: to buy insurance for our portfolios.
Why, then, do some options traders eschew the use of insurance or hedges if they don't make money? I've been advising my Boomer compatriots for half a decade to talk to their investment advisers and brokers about the pros and cons of collaring their long-term portfolios or using other measures to protect against too heavy of a loss. I've mentioned on these pages that when volatility measures are as low as they are as this article is roughed out, it's pretty cheap to buy a little downside protection. [Note: implied volatilities have risen since the article was roughed out, but are still near or at the bottom of their ranges over the last three years.] We don't know what will happen next, but we have history to warn us that, if we ever wanted to consider some cheap put protection, now when volatility indexes are near their lows and equities have just been testing recent highs might be a good time.
In vega-negative positions such as iron condors and butterflies, that insurance may be even more helpful. If equities roll over and implied volatilities explode higher, those vega-negative trades will be hurt . . . except for the insurance puts you bought. See that skew on the OTM puts? The implied volatility is higher in the out-of-the-money puts, plumping up their values more than might be expected. That skew line will curl up even more acutely on the left-hand side of the chart in a sharp downturn, and the puts will plump up more as everyone scrambles to buy out-of-the-money puts. Of course, unless we have a Black Swan event, options at the extreme left-hand part of the chart are going to be so cheap that even a doubling of their values isn't going to help. If we do have a Black-Swan event that drives prices through those way far out-of-the-money strikes, and if that's all you're insuring against, you'll be happy enough with those, though.
The problem is that sometimes that insurance isn't needed. In fact, most of the time, it's not. It may not be now. The history that gets repeated this time may be more like that of the mid-2000's, when implied volatilities just kept dropping while equity prices kept grinding higher. It happened then. It can happen again. We just don't know, so we have to weigh our choices.
Like some of the homeowners in my community, some options traders are never going to buy that insurance. Some are more cautious, like me. But the overly worried can over-insure, paying more insurance than they can afford. Like a homeowner who can't pay the mortgage because of hefty insurance premiums, a balance has to be found.
I knew how much I wanted to spend on insurance when I was trading iron condors all those years, but I'm still finding that right balance for the butterflies I'm trading now. I've spent a number of hours over the last few weeks testing insurance puts purchased at certain levels at certain points in the expiration cycle and then determining how much they would have impacted my profit. They most assuredly will impact my profit. I am willing to take the hit they make to my butterfly position.
What do I want the purpose of that insurance to be? Is the purpose to stabilize my trade long enough so that I can make adjustments? Do I want it to kick in at the level at which I've determined would be the maximum loss I wanted to take on a trade, just in case I wake up one morning with my underlying's price gapping below that level and my loss well above the maximum loss I intended to take? Or do I just want Black Swan insurance?
Each trader will answer that question differently, so there's no one right answer for all. Long OTM puts tend to plump up nicely, as long as they're not too far out of the money, of course, and long puts tend to work better than put spreads in our current volatility environment.
Hedging the upside on an equity trade is a bit more problematic. Implied volatilities drop as equities climb, and the OTM call you bought will not plump up the same way an OTM put would plump up if implied volatilities pop as equities roll over. Some traders use call debit spreads to hedge against upside risk. I use them myself in some of my trades.
Some traders buy volatility products such as options on the VIX as insurance. They might buy VIX calls, for example, as a hedge against an equity rollover. Be careful about that, however, as some traders have found that VIX options just don't behave as expected. Their value is tied to VIX futures and not the spot VIX price. They also have non-standard expirations that catch some by surprise. Some equity traders use bond-related options or ETFs to hedge against an equity rollover, but be careful about that, too, unless you're an experienced bond trader. The typical bond/equity adverse relationships from the past don't always work now and could change in certain geopolitical environments.
Some people consider the small size of their trades to be its own built-in insurance. That's valid if the total of all your trades measures something like 10 percent of your portfolio, for example, and you can afford to lose that all in one fell swoop. However, if you have 75 percent of your portfolio tied up in trades, you have a different situation. Most people can't afford to lose 75 percent of a trading portfolio's value.
Be careful about deciding that your diversification into various vehicles provides enough built-in insurance. We're seeing equities, gold, and bonds all having climbed off their 2008-2009 lows, correlated a bit differently than they used to be in the past. Can we count on them to provide the same diversification that they did in the past in a downturn? In 2006 and early 2007, many advisors touted diversification into emerging and other markets as a way of protecting one's portfolio. They must have missed the studies that showed that equity markets, at least, correlate the most strongly in downturns. That diversification into apparently non-correlating vehicles turned out to correlate much more than expected during the downturn that was to come.
We shouldn't be frightened into buying more insurance than we can afford or need. Neither should we be caught without it when we do need it. Think about it.