The Basics of Dynamic Hedging

Over the course of the week I’ve been describing all the nuance of a specific options strategy known as a strangle position. While the position is extremely cash intensive, it does provide an interesting thought experiment that might provide some additional insights into how it is we can make more out of our existing portfolio positions.

In this article, I’m going to finish off the discussion by describing how it is that a strangle position can be adapted into a contained portfolio in itself, and therefore better managed by a personal investor. With that in mind, I’ll proceed to describe the kind of circumstances that best enable the feasibility of the strategy as a whole.

The trick to managing a Strangle position is to remember that this is a dynamic position. You will always be left with some form of position in your portfolio at the end of the period, and you will always been overly exposed to the stock because of the put position. We therefore need to actively manage our holding so that we can continually improve our ability to handle the risks of the underlying stock, and therefore improve our risk-cushion.

Using a very simplified version of ‘dynamic hedging’, even a personal investor is capable of effectively managing a strangle position, so long as they have the time to keep a close eye on their portfolio.

For this reason, I like to look at this strategy as being in a pseudo-fund on its own, and then measuring its impact on a greater portfolio as its own position. You don’t want your holdings in the pseudo-fund to outweigh the value of your entire portfolio on its own, so you can then tailor your holdings to fit into your overall investing capacity.

Remember, even the unallocated cash that you are using to cover the put contracts is intrinsically allocated to the security, and so you should have a large enough portfolio to diversify against even that balance. If you’re position isn’t big enough yet, maybe consider saving this strategy for later in your high-earning years.

Once you’ve separated out your pseudo-fund, you can begin to enter in your orders. However, as soon as you’ve entered those positions, it is important to constantly monitor the underlying security. Stocks can drop by 20% in a day, and then re-correct in the following afternoon. These sorts of unpredictable movements are enough to break your position in a solid week. However, if you’re able to keep an eye on your positions, and re-balance your options contracts as they are executed, you can continually maintain your somewhat neutral position against the market, and continue to generate cash-flow.

By following this practice of continual readjustment, executions are no longer a risk, but an opportunity to incur additional cash flow that will average down your position and increase your risk buffer. So long as you are able to find a buyer of your options contracts, you’ll constantly find yourself earning an income on this position, more than compensating you for the amount of time you need to spend watching the position.

Better yet, if you have an investment advisor or broker (highly recommended), you can ask them to monitor the position for you, and ask for them to notify you about the position as it is impacted by price changes. This allows you to go about your daily life without having to check Google finance on your cell phone every fifteen minutes.

The last point I’d like to make about this dynamic process is that you can never shift the strategy into ‘autopilot’. There is no such thing as ‘free money’, and so there is always a risk associated with this sort of position. For example, if the underlying security consistently decreases over time, you’ll find the percentage yield that you receive from the options will decrease, therefore reducing your cash flows from the position.

As time goes on, you’ll be less able to dilute your previous higher-cost positions that were put to you, and you’re ability to mitigate risk will decrease. Additionally, if the stock is decreasing due to insolvency risk, you might find that you are less able to sell your positions into the market, and that people are more likely to execute put contracts underneath you. This is again unfavourable, because, unless you somehow have unlimited amounts of capital available to continually float your position with, you’ll quickly find yourself overburdened by your pseudo-fund, as you need to continually dedicate more and more cash towards supporting the risk-buffer. While you’ll still be making money all the way through, you’ll be increasing your exposure, which means you’re more highly exposed to the underlying security, and have more to lose if something dramatic occurs.

So how do we know if a Strangle position is right for our portfolios? We ask our advisor. Same as always. Your ability to bear risk will always be specific to your individual situation, and so tailor it accordingly.