Bargain hunting made easy with dynamic hedge

The recent week has shown a downward move which could be at least considered as a Bull Market Correction. Some of us were sad by the losses on the Buy Positions but a part of all of us was happy. Happy, because the much-needed price correction was in front of us.

Now, the big question is, when we say Bargain Hunting in correction, do we mean calling a bottom? As we all know, no intelligent person has ever caught a perfect bottom. In this quest of bargain hunting, we run a huge risk of further downside.

What do we do?

We hedge, but dynamically.

We all know the hedge part but let us still refresh it first. We are referring to a Buy position in the Future at a lower level but with a simultaneous Buy position in the Put option (Option to Sell) of the same expiry and a strike price that is closest to the current market price.

So, we have an Option to Sell at the strike price at all times. This precisely makes the strategy a limited and known loss strategy.

Being able to make a Buy trade knowing that the losses will not exceed a specified amount will always make it simpler to Bargain Hunt. However, there is a problem. The problem is of Volatility. Since catching a perfect bottom is next to impossible and the commotion after the fall will be too high, we could have 2 specific problems.

1. We buy and then there is a further fall before the rise back reignites (Deeper Bottom).

2. We buy, we go up a bit, and then fall Back again to the same level (Bouncing Bottom).

3. Both of the cases will make our traditional hedging inefficient. In both cases, time spent in establishing the bottom will cost us time value-related losses in premium terms.

Let us face it the positions are held till expiry only in textbooks (very rarely held).

Dynamic Heding helps with this. Two different shifts are used in each one of the cases:

Downward Shift

When we see a continuation of the fall, we sit tight till we notice a halt. However, unlike traditional hedging, as soon as we see a halt with the possibility of reversal, we act. The action is Booking profits in the Buy Put option (Must be making money since there was a fall). The second action is to Buy a lower strike Put now that is closest to the current market price after the fall.

Now in most of the cases, such falls are just an extended bottom. In case of a reversal the Hedging cost will go down significantly. The downside to this is that we will have a bit of extra loss.

Upward Shift

In case we see a reversal fails to sustain. Book a Loss in Put option (Premium must have fallen with a rise). Buy a new Put with a strike close to the current price after the rise.

This will also effectively optimize the hedge cost by now giving protection from a much higher price than your buy price.