A Cheap Way to Protect Your Portfolio From Market Crashes

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I want to flash traders back to the flash crash. The fund I work with had entered a May S&P 100 Index (OEX) butterfly that was doing reasonably well until the first week of May.�

When the market began to fall away from my short strikes, at one point the trade was down almost 10%, even after all of the hedging and adjusting we did. Then, on May 6, the flash crash happened, and we made a bloody killing.�

Why? Because I was long what most market makers call “units.” Thanks to these units my butterfly position, which by itself got killed by the crash, was more than protected.�

A unit is an extremely inexpensive option that has unpredictable Greeks, to say the least. All units will have deltas below 5, and little to no gamma or vega.�

I break them down relative to product: The more expensive the underlying, the more expensive the unit. For instance, in the SPDR S&P 500 ETF (NYSE: SPY), an option becomes a unit around 20 cents. In the S&P 500, an option is a unit closer to $2.��

How Do Units Work?

I like to compare option trading models to Chicago Bears quarterback Jay Cutler — great between the 20s, but not so great beyond that. Nowhere does this rear its ugly head more than in super-cheap options. Inexpensive options, especially puts, tend to gain far more value than the model predicts.�

What is the cause of this volatility? One of the major issues with most models, especially those used by the retail world, is that they predict uniform increases in volatility. This simply 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? Like a seesaw, the more one moves down the board away from the fulcrum, the further the distance that the wood will move.�

There is another factor, though. Since the fat guy jumped on the piece of wood, the wood will have moved violently. This causes the wood furthest 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 at-the-money (ATM) puts, downside puts, you name it. Every trader that is selling or short these puts races to buy something that will protect his or her position in case the market absolutely tanks.��

So these shorts buy units, and 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, which in turn causes the unit to gain more value as traders race to buy them to protect sales, which raises vega � you get the point. In short, there is a snowball effect.�

How to Trade Units

Here is an example of exactly what we saw at the fund in the OEX trade. On April 20, we bought the OEX May 505 Puts as a hedge against a short iron butterfly. When the market fell on May 6, these options were worth almost $10. On May 7, they closed at $14.50, a return of more than 1,200%. Not bad for an option that cost us $1.20.�

So how can the average trader use units to increase the returns of his or her portfolio?�

That’s easy. Buy units, but not a huge amount. At OptionPit.com, we teach that 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 is no longer losing money, or possibly gaining value. And if the market drops 20%, then the trader should be making money.�

Obviously, the math is not that simple. Understanding how units work comes with understanding volatility. When I am teaching at OptionPit.com, this is only one of the steps we take to ensure our traders are safe. After all, trading is not easy and nothing is for certain, but by properly implementing units, I am willing to bet that a trader will never have to sell his or her house because the market dropped 25%.

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