The hedging strategy that pays for itself
The core theta strategy we use in our main portfolio carries a significant amount of negative Vega exposure. This means that when volatility expands rapidly, our positions will take on losses rapidly, even when price movement is not large enough to breach our short strikes. Our 112 positions can potentially take on massive losses in the event of a volatility explosion.
The above chart shows the risk profile of a typical 112 position that still has 94 DTE remaining. The three lines represent P/L levels of this trade at three levels of implied volatility.
-The purple line represents current volatility levels (as of writing this guide)
-The blue line represents an increase in volatility of 10%
-The pink line represents an increase in volatility of 20%
The P/L values circled in the bottom left show the variability of loss based on volatility levels when price action stays at its current level. The degree of loss can get out of hand quickly as volatility reaches higher levels. This magnitude of volatility increase does not come often but it is common enough that we must prepare for it or risk taking significant loss. Ordinarily the underlying price would not remain the same as in a volatility explosion the underlying is typically crashing, leading to more losses. The purpose of this chart is to show what effect volatility can have on a position even without accounting for a change in price level.
To help give us some cushion against such an explosion of volatility, we hedge our portfolio and we do so in a way that doesn’t put a large strain on profitability. We employ what we call the 3-5 Black Swan Hedge Strategy. This is a strategy that can build up a large amount of protection for a very low net cost. In fact, in most cases we end up taking in overall credit when the trade is complete. The end goal of this hedge is a net long put position. In a volatility explosion, the price of these puts would expand exponentially which is precisely what we want. Below is an image showing the performance of a single tranche (with 94 DTE remaining) of this trade under the conditions of a market experiencing a 0%, 10%, and 20% increase in volatility.
The risk profile is the opposite of the 112 trade. As underlying price goes down and volatility goes up, this trade becomes increasingly profitable. This trade will not negate the effects of an outsized market move on our 112 positions, but it can help to dampen the effects, especially when we can put on multiple layers of the trade by keeping the costs insanely low.
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