Option Investor
Educational Article

Bullish or Bearish - Stay hedged, Make Money, Part II

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The last time we had a chat in this column was on July 18th where I promised I'd get to the "adjustment" phase of the hedged strangle or straddle trade "next week". Woops! I missed a week! And what a great week it was for me personally, as I got to take my eight-year-old daughter to Disneyland for her first visit. She had a blast - liked it better than Disney's Big Red Boat and Disneyworld.

Little did we know what lay in store for us at the newest park in the Disney chain, Disney's California Adventure. It was awesome! For those that haven't been to Disneyland for at least two years, or not at all, the California Adventure was built right where the old parking lot used to be. I couldn't recognize the place. Anyway, California Adventure, my daughter and I agreed, was even better than the regular Disneyland, though we still liked the Magic Kingdom a whole bunch too.

Why do I bring up this Disneyland stuff (other than to artfully fess up as to why I didn't write last week)? The answer is because I was planning to do a Fundamentals Guy piece upon returning from my vacation as to why Disney (DIS) might or might not make a nice investment in a tumultuous market. Because the service at the parks was first rate, and the parks were populated like I'd never seen before with happy faces freely spending money (What recession? One $8 hamburger please.), I figured Disney must be making a huge amount of cash worthy of my investigation if not my investment.

Further research proved me wrong thanks to a bunch of debt and the possibility of drastic travel and entertainment budgets cuts at the family level in coming months if not years. Dividend yield wasn't too hot; neither was the earnings multiple. That would make a boring story. Then I remembered (and was reminded by a few e-mails) that I promised a follow-up to the last column. And that, Dear Reader, just like explaining how to build a clock when asked for the time, is how we arrive at today's topic of adjusting our hedged straddle or strangle. For those that missed the last article, you can get up to speed at the following link:

http://members.OptionInvestor.com/options101/071802_1.asp

On with the story. Remember that we want to be market agnostics by not thinking "bull or bear". We go where the market tells us, and we let volatility premium decay on the other guy from our short positions. We profit no matter what as long as we remain hedged in the direction of the trade. With that in mind, let's get to the fine points using the QQQ trade we referenced earlier. Recall that we were short the AUG-25 straddle (a put and a call). The following daily chart shows support and resistance as of July 18th.

QQQ daily chart:

A breakout over $26.50 resistance would be enough to get my attention to go long QQQ shares, which hedges our $25 call position and locks in a $1.50 profit for us as long as QQQ remains above $26.50 by expiration. Similarly, a breakdown under $23.50 is going to get me going short to hedge the $25 put, which also locks in a $1.50 profit as long as QQQ closes under $23.50 at expiration.

Here's my logic behind picking $26.50 and $23.50 as pivot points. That's where we find support and resistance. We could just as easily pick $25.25 and $24.75 as pivot or hedge points, but clearly, that will have us in and out, short and long, possibly many time during our hold period to expiration. The other side of the coin is that by picking $27 and $23, we run the risk of wiping out a big part of our collected premium from the short straddle/strangle. By waiting that long to hedge, we let $2 of the $3 collected premium get away before protecting ourselves - not much of a return there, and reversals of the underlying stock back under $27 or over $23 would whittle away at our remaining $1 profit. We must pick a strategy here and stick to it.

This may seem trivial like a background explanation, not the main point. But it is the essence of the real dangers of this trade. If you get nothing else from tonight's article, understand this. Profits will be eaten alive and can turn into a loss if the underlying gets stuck trading around a pivot point and we do not ultimately exit the trade while there is till money in our pocket. Note the updated QQQ chart below.

Current QQQ chart (daily):

Eeeeew. . .that doesn't look so good, does it? Nope, but if we're smart we still come out ahead by evaporating vega and theta (volatility collapse and time decay). But let's follow the course of action here. First we went short when, at the end of the day, we saw a close under $23.50. Three days later (long green candle), QQQ closed at $23.63. So we follow the discipline and buy our short shares back. Bummer - because the next day, we short again when the QQQ falls under $23.50 (next red candle). Two day's later, BAM! Gap up and close over $23.50. So we cover our short shares by purchasing them back. Today (last red candle), back under $23.50 so we are short again. Ideally, every time we stick around a pivot point, commissions will be the most expensive part of the transaction since bid/ask spread on the underlying should be minimal. Spreads will be almost neutralized if we are going short and getting filled, then covering the shorts with stop orders. Simply set a limit order such that when QQQ trades below $23.50, we get short the shares. Hopefully it continues down. NO? Ok, once filled, we then set a stop limit at $23.50 to cover our short shares if the price moves back up. Lather, rinse, repeat.

Now all this can get pretty expensive commission-wise even with a small spread on the underlying. If we get tired of the in and out action, we can simply cover the short while simultaneously buying back the short straddle. The bid/ask spread on the options will be much more noticeable here and can slurp off what little profit remains. We might get out with a small profit or loss. But the point is to plan to close the whole trade if it isn't going our way. Don't let a profit turn into a loss from overtrading. Get out of the whole thing and re-evaluate or do a different trade.

Just for grins and giggles, suppose we are type A traders that won't leave an ounce of wiggle room on the $25 straddle. With that mentality, a large enough short straddle position, which won't be drastically affected by commissions, and the ability to watch our charts minute by minute, we might have decided to stick to $25 even, as our pivot point. Long above $25; short below $25; no emotion; no second guesses; a pure trading machine; long or short as we hit the $25 number. In that case, we would have been short two weeks ago and never looked back - that $3 premium still in our pocket.

Now, are the dangers and rewards apparent? Can we now understand why trading style has everything to do with the profitability of this play and why discipline to sticking with the strategy is so important? That's one of the reasons I was careful two weeks ago to suggest readers NOT make this trade unless we had full understanding of the strategy. Again, short the straddle or strangle to take advantage of expensive volatility premium and time decay. Then let it evaporate on the other guy while we hedge in the direction of the underlying security - short under the strike price, long over the strike price. It's really simple.

But as we get more comfortable with this strategy, we can make it even more sophisticated. Here's a great example of one our sharp- brained readers getting it absolutely correct with an edgy twist, edited for brevity. Beginners, don't try this at home without a thorough understanding of what you about to read. . .and for gosh sakes, paper trade it first with pretend money!

Reader T.D. (probably stand for touchdown!) writes:

Hi Buzz,

Waiting with bated breath for the follow up to your 18th July article. Because of the high premiums available I have several short straddles, short strangles and naked puts/calls open on individual stocks.

So far the hedges have been simple but there is bound to be a time when I get a dreaded oscillation about a strike. :-( [author's note: see above] Gap openings are another danger of course but I do each of these positions in relatively small size so any single problem should not be too much of a disaster. Perhaps I will already be hedged (in the right direction) when if it happens - I can hope.

I view these trades as number of points credit available to cover me against adverse events and I have adjusted them as time goes by in order to add more "points" to the position.

e.g.

Sold 460/500 strangle for 54.

Price fell below 460 - sold underlying @ 459 for the hedge.

Price fell a little further.

Closed 500 call, sold 460 call for a credit of 7. I now have a 460 straddle with 61 points credit and a short hedge already in place.

Price fell further still.

Closed 460 call, sold 420 call for a credit of 9. I don't know the technical term for this but I now have a strangle again but with the call price below the put. I also have 70 points credit and a short position in the underlying.

Underlying bounces back above 420

Close hedge @ 420 losing 1 point since I did not protect the 460 put until 459. (in fact there was an obvious intraday "bounce" taking place so I closed earlier. This created an extra profit but is not included here since as you pointed out, we do not trade the underlying in these positions. I did; took a risk and it worked. This was an EXTRA decision and nothing to do with the other principles discussed here).

The price now is between the 420 and 460 strikes so no underlying position is in place; but sell and buy stops are.

I am new to options but not new to trading. It seems to me that the more premium I can take in on any position, the more protection I have and downside protection is always my FIRST consideration. Profit is OK but not losing is even more important. [T.D nails the philosophy exactly right.]

The position above is now 69 points up so I can now stand more things going wrong. Also I am now back in a strangle which appears less risky than a straddle since the adjustments may be less frequent with a "free" area to work in.

I would be very keen to know when you will be publishing the follow up. I can only hold my breath for so long :-)

Thanks a lot. Love the site.

T.D.

Thanks T.D.! It's great e-mails like this that make our day and convey to us that OIN readers have learned how to fish, not just accept the gift of fish!

In an ideal world, this is exactly how a trade is supposed to work out. For the article, in order to keep it simple, I had planned merely to talk about shorting the underlying at [in T.D.'s example] 459 or going long at 501 and let the short options expire. But he already knew to do that and some better by covering and shorting the option on the way down, thus getting vega to work even more in his favor. He swerved into an effective strategy - Nice Job!

I know this is a hard strategy to get at first for the uninitiated, but it will sink in, and once understood is very simple. Again, short expensive options so that volatility and time decay works in our favor, and hedge in the direction of the underlying security. It's kind of like a jet getting off the runway. It requires 103% power just to get off the runway, but once airborne, we can climb and fly faster with less power.

Questions always welcome. Trade smart and make a great weekend for yourselves!



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