Option Investor
Educational Article

Bullish or Bearish - Stay hedged, Make Money

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Everybody loves a bull. Nobody loves a bear, except when he helps a former bull make money. Call me "Buddy Bear". (I think Jimmy Buffet (not Warren) wrote a song about "Buddy Bear" many years ago.) That, Dear Reader, is my intent for today - to be your Buddy Bear. It is no secret that we are locked into secular bear market, probably for years to come. However, that doesn't mean we can't make money on the bullish side by trading a cyclical bull, which WILL happen. It's just a matter of time. Trouble is, we don't when this secular bull will show itself, and we could be killed by whipsaw volatility while waiting to be right. That's no fun.

What to do? Maybe there is a way to use high volatility to our advantage rather than having it cost us money. Maybe there is also a way to make money that doesn't require us to be right on market direction. Will the market sink further from where we are now? Or is the oversold condition of the market so tightly spring that markets can't help but explode to the upside beginning, ummm. . .tomorrow? What if we could find a way to avoid picking sides, and to maximize profits in the process?

The good news is that Fundamentals Guy is going to spare us all the usual rant tonight in order to demonstrate a potentially great trading opportunity that is market neutral and takes advantage of the current high volatility premiums on options. Anybody think we want to buy options - puts or calls - in this environment and wait for them to rise? Nope! We want to SELL options to maximize our take while preserving our principle. After all, huge premiums belong in our collective pockets so their value can evaporate on the "other guy". So how do we do that? What I'm about to show is a simple hedged straddle or strangle.

First the definitions: A strangle is the hedged use of two DIFFERENT strike-price options. A straddle employs the use of two of the SAME strike-price options. For instance with the QQQ trading at roughly $24, a strangle would employ the use of say a $23 strike and a $25 strike while the straddle would employ the use of two $24 strikes.

Since the VIX (volatility measure of the S&P 100, or OEX) is historically high at 39.69, and the VXN (volatility measure of the NASDAQ 100, or NDX) is historically high at 63.61, let's sell some of that juicy premium! For that we'll stick to our current example of the QQQ (NASDAQ 100), currently at $24.73.

So here's what we do. We simultaneously SELL a QQQ straddle of say the $25 strike price, which is to say we sell a $25 call and a $25 put. Ideally we do this when the QQQ is exactly at $25, but we are close enough right now. That begs the question of which one - current month or some back month option do we sell? To aid in that decision, remember we want the biggest time premium evaporation possible, and that means current or front month, not back month where the duration to expiration is, by definition, longer. We won't use July options because those will expire tomorrow and carry very little premium. So August strikes will give us the biggest bang for the buck. September strike don't suit our purpose either because of the lengthy term to expiration and volatility premium falls off the further off we are from expiration.

Checking prices, we see that the AUG-25 call is $1.40 bid by $1.50 ask, and the AUG-25 put is $1.60 bid by $1.70 ask. If we sell the straddle at bid, we take in $1.40 for the call and $1.60 for the put for a total of $3.00 premium. By definition, at expiration in August, one of those will be in the money and one will out of the money, but we don't know which yet. And $3 may not be enough profit to cover a substantial move against us - say under $22 or above $28. So we have a great short straddle with money in our pocket, but how do we protect it from moves that are guaranteed to call us out or put stock to us?

The answer is simple. We hedge by going long or short actual shares in the direction of the trade. Here are the two possible scenarios. First, the price can move down from $25, which sets us up for having stock put to us at an expiration date close at under $25. Anything under $25 has the QQQ put to us at the then closing price. Conversely, the price can rise above $25, which sets us up for having the stock called from us at an expiration date close at over $25. Let's follow each of these scenarios to see how the hedge is put in place that allows us to keep most of the sold premium.

Let's break this up into two parts. What we will be watching for is a break in either direction at from $25. Suppose we are watching and waiting for the perfect moment to enter our trade. We find it as the QQQ price hits $25. Then and there, we sell the AUG-25 straddle for $3. Let's see what the chart looks like here.

QQQ daily chart:

Notice that support and resistance has been pretty steady between $23.50 and $26.50. In purely technical terms, I'm going to expect it bounce around in that range. If this were to happen through to expiration, we would be forced to buy shares at $25 if put to us, which would then be sold at a loss, say at $23.50 worst case. But that's OK because we collected $3 up front for a net gain on the whole trade of $1.50 on $25, or 6% for the month. Not bad.

Similarly, we could be forced to sell shares if called away at $26.50. We would then buy the shares to cover at $26.50 and sell them at $25 to the call holder for $1.50 loss. But remember we took in $3 up front so our net profit is still $1.50 here too.

However, once it quits bouncing around and makes a move outside of support or resistance, we hedge in the direction of the trade. I'll split this into two sides again. Think of this as writing a covered call OR a married put simultaneously.

Let's say QQQ breaks over $26.50, we would then simply go long QQQ shares in an amount sufficient to cover our short call position. In essence we would have a covered call and a short put. We could never lose more than $1.50 on the covered position because it is offset by our $3 premium we sold. Even if QQQ goes to $30 or more, we win. Why? Because we own shares bought at $26.50, or slightly more, when we covered that are increasing in value right along side the call buyer's option.

Now, let's say the price falls under $23.50. We would still hedge in the direction of the trade, only this time we would short the number of shares to match our short put. Remember, we are short put options which gives the right to the put buyer to "put shares too us" at a price of $25. By going short the shares, we take in $23.50 per share and effectively build in a loss of $1.50 ($25 cost minus $23.50 income from the short). But remember again that we took in $3 in option premium at the start. So we still have a net profit of $1.50 even if the price falls to $20 or less. As our short put becomes more valuable to the put buyer and costs us money, we have an offsetting position of short shares (a married put) that gain equal value as the price falls.

The beauty of both of these examples is that we are hedged and we pick our hedge based on which way the QQQ moves. We will want to be short shares at some point under $25 and long shares at some point over $25.

Of course, there will be adjustments, and we may want to pick our trigger points to get long at $25.50 or $26, or , and get short at $24.50 or $24, or .

Now all that said, and despite that it's a great way to collect expensive premium, which evaporates on the "other guy", I encourage everyone to fully understand and plan this trade before we ever enter it. The worst things we get around here are e-mails that say, "I took your recommended trade and the price got away from me and I'm going to get killed. What do I do?" First, this is not a recommendation to take a QQQ hedged, short straddle trade. It's an example only. The trade can be done on any optionable equity, and some are better-suited for this strategy than others.

Second, since prices fluctuate, a breakout or breakdown that causes us to get hedged following the strategy can reverse back, which forces us to adjust our hedge again. And that gets into the whole question of where do we adjust? We have not covered that here tonight, but will in another episode within the following week.

Yes, bait to get you to read part II!

But for the traders among us that have employed this strategy before, now is a good time to dust it off. For there is no time like the present to take advantage of this markets high volatility. Bull or bear, our job is to make money on this trade as a market agnostic. No opinion necessary to make this strategy work!

Trade smart and make a great weekend for yourselves!

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