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Hedge Or Bail?

Posted by Pete Stolcers on January 12, 2009

Option Trading Question

Many experts advise cutting losses at 7-8% below the purchase price of a stock - no matter what. Is it a good idea? Is it a good substitute for hedging by shorting the market?”

Option Trading Answer

William O’Neil is one expert who advises the referenced strategy. I think he is a brilliant investor and his methods are valid in the right context. He identifies stocks with good price and earnings momentum and his approach gets him out when the “tide has turned”. Realize that his method is a general guideline to a massive audience.

I prefer to always stay hedged with long and short positions that display respective strength/weakness. For each stock I outline my expectations and I identify support/resistance levels. How the stock behaves relative to the market and how it acts at these levels will determine my actions. I have found this stop approach to be more effective (relative to a standard percentage) since each stock is unique.

More specifically, my previous article addressed a portfolio of option positions that had one-sided (bullish) market exposure. If the trader still felt that the positions were legitimate and he needed short-term protection, the SPY hedge would have been an effective way to reduce risk and weather the storm. If his opinion changes, it will also allow him to calmly exit the call positions. He now has the latitude to work the orders as opposed to hitting bids. The bid/ask spreads are often a mile wide and they can represent 10% of the underlying price of the option. If he bailed on all of the positions and got back in when the dust had settled, his slippage would have been extremely high (relative to the SPY hedge). Getting out of option positions at a fair price can have a big affect on performance.

If a position does the unexpected, you should look to get out. If it is moving in sympathy with the market and it still looks relatively strong, a short term hedge might be the answer.

Thanks for the question. 

Option Trading Comments

  • On 06/07, Mike said:

    I think Pete’s strategy is the brilliant part and it makes infinitely more sense than O’Neil’s outdated absurdity. (That strategy probably worked fine when W.O. was Pete’s age.) Setting stops at 7-8 percent these days is not only ridiculous, it’s often downright impossible--especially during earnings season. I’ve lost count of how many stocks sink by TEN percent or more OVERNIGHT because of news or earnings! What does his "brilliant" strategy say about that? Hell, I’ve seen many momentum issues move that much INTRADAY. If you set stops at 7-8 percent, you’d be stopped out several times a week on some of these! They only really work with large and/or slow names. Stick with Pete’s philosophy--he doesn’t have to sell a newspaper or books to make his money. I speak from years of losses by not following that kind of hedging strategy. Thanks again, Pete.

  • On 09/08, Steve said:

    What is a good way to mimize loss when the underlying stock on which I sold a covered call tanks, with little chance for rebound?  Do I wait for the existing option to expire or buy it back before expiration for pennies so I can move on before further loss in stock value?  Should I buy a protective put as insurance while waiting for expiration?

  • On 09/10, Pete Stolcers said:

    You are correct. You always have to have a stop level in mind for the stock. Once that level is breached, you sell the stock and buy back the call. I use trendlines, horizontal support and resistance levels and major moving averages. I cover risk management in my course, “Covered Call Writing - The Right Way”.

    When you have a strategy with limited upside and unlimited downside, you have to make sure that you don’t expose yourself to big losing trades.

  • On 10/28, John Vati said:

    I have a large potfolio of options as a writer. The practice here is for the clearance house to be provided with a daily calculated margin and the same amount to the broker as collateral security.
    The broker has recently advised they are measuring client’s ability to withstand a 25% drop (for puts) and 10% increase (for calls) as a “sress test”.

    How would you advise a trader to approach this hurdle?

    I have just found your website and I think its terrific!!

    Looking forward to your prompt response,

    Kind Regards
    John Vati

  • On 10/29, Pete Stolcers said:

    As a former SVP for a brokerage firm, I love it. It is a healthy exercise and as a customer you can take comfort knowing that the firm is controling risk before it becomes a problem. They are identifying potential problem accounts. This is typically done when the roof is caving in.

    Writing has a very numbing affect. If you do it long enough, you feel infalable. Time ticks by and income is generated. Of course, everyone has their safe guards thinking that if the stock (or the market) tanks, I’ll have my stops ready. That might work 99% of the time, but it is the 1% you have to worry about. I’ve been through Black Monday, the mini crash of 1989, Long-term Capital in 1997, 9/11 in 2001, the 2008 crash in Sept/Oct and even the flash crash this year. You might think you are ready, but an overnight gap can destroy you and the brokerage firm you clear through.

    Your brokerage firm is doing the right thing.

    As a trader, if my margins are jacked up too high, I might move the business. I feel that 20% of the strike is fair for equity put writing.  You did not mention that your margins are being increased, only that an evaluation is being conducted.

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