Hedging Option Positions
Posted by Pete Stolcers on June 5, 2006
Option Trading Question
Today Sam P. asks, “How can I keep from getting headfaked out of good options positions when the market moves against me?”
Option Trading Answer
I know exactly what Sam is talking about. Let’s say that I was bullish and I started scaling into long call positions last week. Today, when the market broke down I didn’t want to close all of the positions because I like them and I didn’t want to get chopped up getting in and out.
Normally I try to carry a balance of long and short positions. For argument sake let’s say that I only have “long” market exposure. In that case I will short the SPY (or S&P 500 e-mini futures) for protection. It is very liquid and the bid/ask spreads are tight. The hedge is easy to execute (one order), I can keep my original positions and my slippage is low compared to the alternative. Calculating the amount of the hedge is tricky. It depends on how much of my bullish bias I want to keep. The duration and nature of my positions (ITM, OTM) also matters and so does the beta of the underlying stocks. If I have picked good relative strength the hedge will work well. The SPY will drop more than the stocks I’m long and the options will retain their value. A crude method for calculating the number of SPY shares to short would be to multiply the number of options by the delta and the stock price. Then, divide that number by the price of the SPY.
Long 5 July 50 calls with the stock at $48 and the delta is .5
Long 5 Aug 40 calls with the stock at $40 and the delta is .6
Long 8 June 60 calls with the stock at $63 and the delta is .9
(500 x 48 x .5) + (500 x 40 x .6) + (800 x 63 x .9)/127.12 = 545 shares.
Once the hedge has served it’s purpose and the storm has passed, you can buy in your short position. Your gain on the short SPY should offset the losses on your other positions and you won’t incur all of the slippage and work of getting in and out.
Sam selected a free one month subscription to the Level 2 Option Report as his reward.