Yesterday JNJ closed above the $62.25 adjustment price threshold given in the analysis for Monday’s hedge trade. That price level was based on the simple idea that we can close a hedge position once the underlying is back above the price that triggered the adjustment and the hedge position no longer has positive theta. Since then we’ve been looking at an alternative— neutralizing the hedge-trade delta by adjusting the position rather than closing it, thereby turning a losing hedge into additional profit potential.
We’re also working on better ways to measure risk than our current rules, which hinge on position strikes and simulated expiration breakevens. One idea is to use portfolio delta as a percentage of capital at risk to set adjustment triggers. At first it might sound a bit complicated, but it’s actually more straightforward than our existing rules, especially when we’re dealing with a portfolio of three or four overlapping positions. The main reasons in favor of a delta-based approach, however, are the following:
- More quantitative – We’d be using a mathematically determined measure of actual current short-term risk.
- Greater precision – When we have several positions open, averaging the risk-management thresholds, as currently defined, for different positions and combined positions leaves too much room for subjectivity.
- Greater flexibility – With the current system, the rules for setting adjustment thresholds are complicated enough that we wouldn’t want to confuse members by having different variations for upside and downside risk-management price levels. With a quantitative, delta-based approach, we can specify different percentages for positive and negative delta thresholds, but the method for measuring current portfolio delta against our adjustment triggers would entail the same simple calculation.
I’ll have more detail after further backtesting. In the meantime, however, we’re going to use our JNJ Supplemental Trades portfolio to demonstrate how the new risk-management rules might work. The immediate impact for our open trades is that we’re now looking at an upper adjustment price threshold above JNJ $63—so we’re not on adjustment watch today.