Huge drop in equities - a test of our hedging programme

Hedging "short" option components of a trading portfolio is always a tricky question. If you hedge and it is not required, you can lose lots of small amounts, while if you don't hedge at all, you occasionally suffer breath-taking losses (and I do mean breath-taking). The trick is to decide where the pain gets too much, hedge it away when it hits these levels and then exit the hedges later, hoping you don't get hit again after that.

After three or four weeks of trading in a tiny range of about 100 points the FTSE dropped around 2% on Tuesday, and has dropped around 200 pts in the past three days. With less than two weeks till our short position in March options expires, our hedging points were quite close to the market price and three were picked off during the afternoon's fall.

But then a rally gets underway on Wednesday morning, volatility drops and our hedges start making losses. We partially exit the hedge and the market starts to fall again! Such is the fate of the short option trader. Mark to market, our March option position is currently in profit to the tune of 25% of the premium we wrote. Remaining time value decay would take this to about 50% of the premium write. Hedging has cost about 5% so far. So if things remain as they are, we will still make around 45% of the premium write this month. On average we make about 35%, but with a huge variance. Without hedging the numbers vary from about 150% to -300%, translating into a +10% monthly return to -25%. Hedging keeps the worst months to about -5 to -10%. So whenever a hedge costs us money we should remember what can happen when we don't hedge!

But frustrating all the same.