The following is an example of how to protect your portfolio against a black swan event. Look back to the flash crash of May 2010. A fund had entered a May OEX butterfly that had been doing reasonably well, until the first week of May. The market began to fall away from the short strikes. At one point the trade was down almost 10% on the butterfly, even after all the hedging and adjusting had been done. Then on May 6, the flash crash happened, and the position made a killing. Why? Because the fund was long what most market makers call “units.” These units enabled the butterfly position, which by itself got killed by the crash, to be protected by the options.

A unit is an inexpensive option with unpredictable Greeks. You can break them down relative to product, so that the more expensive the underlying, the more expensive the unit. For instance, in SPY an option becomes a unit around 20 cents; in the SPX an option is a unit closer to 2.00. All units will have deltas below 5 and little to no gamma or vega. So how do these units work?

One of the major issues with most models, especially those used by the retail world, is that they predict uniform increases in volatility. This sim- ply is not the case. When the market makes a violent move downward, two things happen:

1. Front month options increase in value far more than any other month, in relative terms.

2. Downside puts gain far more value than the model predicts.

Think of the volatility curve in a strong down move like a thin piece of wood evenly balanced over a fulcrum. If a fat guy jumps on one side of the wood, what will happen? As with a seesaw, the more you move down the board away from the fulcrum, the more in distance the wood will have moved. There is another factor though: Since the fat guy jumped on the piece of wood, the wood will have moved violently, causing the wood farthest from the fulcrum to temporarily bend upward.

This is the way cheap puts act in a major down move. In the panic, the world is buying ATM puts. Every trader selling or shorting these puts races to buy something to protect the position in case the market tanks.

These shorts buy “units” and all of this buying causes the unit to gain a little price, which increases vega, which increases delta, which increases the value of the unit as the market tanks. This in turn causes the unit to gain more value as traders race to buy these to protect sales, which raises the vega…you get the point—there is a snowball effect.

Here is an example of exactly what happened with the fund in the OEX on April 20. The fund bought the OEX May 505 puts as a hedge against a short iron butterfly. The puts were bought for $1.20. When the market fell on May 6, these options were worth almost $10, and on May 7, they closed at $14.50, a return of over 1,200%. Not bad for an option that cost $1.20.

So how can the ordinary trader use units to increase the returns of his portfolio? Buy units, not a huge amount, but about 5% to 10% of allocated trading money (not the total account value), should go into puts, against a standard set of spread trades (condors, butterflies, and time spreads). This amount should be enough so that, adjusted for any increase in volatility if the market drops 10%, your position no longer loses money and possibly gains. If the market drops 20%, you should be making money.

The math is not that simple. Understanding how units work comes with understanding volatility. By properly implementing units, you are willing to bet that you will never have to sell your house because the market dropped 25%.

The Option Trader’s Hedge Fund
ISBN-10: 0-13-282340-3