Last week's article discussed beta weighting. What would happen if, on May 15, a trader had wanted to set up a bearish SPX butterfly yet hedge it so that it wouldn't suffer big losses if the SPX headed up instead of down?

The Original Butterfly:

We tested a couple of SPX call hedges. One, a JUN 1390 call, resulted in a white T+0 line that looked pretty nice. However, if the SPX did climb and implied volatilities dropped, that T+0 line would sink, too. The extrinsic value in the out-of-the-money 1390 call would be impacted and the call wouldn't hedge as well as it first appeared it would. To see how we tested this, review last week's article at this link.

We tried an in-the-money call, but that call still had $15.89 in extrinsic value. Moreover, it produced a ridiculous-looking profit-and-loss chart that produced large losses if the RUT headed toward the center of the butterfly. We needed a lower-cost call. The SPY options might work, but we needed a way to determine which SPY option and how many of them.

First, we wanted to choose a SPY option that will have little extrinsic value. How much is "little"? That can vary with the observer, but let's be stingy, and say we wanted no more than $0.20-0.25 of that option's price to be extrinsic value. If the SPX climbed, we wanted the SPY option's price to escalate, too. We don't want any shrinking extrinsic value as implied volatilities fall to undermine that option's ability to hedge to the upside.

On May 15, the SPY JUN12 114 call had an extrinsic value of $0.25. This deep ITM option will perform well as a stock surrogate. Beta weighting the position against the SPX, a task that can be easily performed on many platforms and charting systems, allows us to assess how the trade would perform. In the chart below, you'll see that the SPX is the "beta symbol" listed in the top left-hand corner of the chart.

Beta Weighting the Position with Three SPY 114 Calls:

Choosing the right option and the right number of contracts is a judgment call. The green "Live" line shows this combined position has a beta-weighted delta of -6.93, a modestly negative number. Some traders might have preferred to buy only two of those SPY 114 calls, resulting in a more negative delta of -16.23. The white line would not have sloped down quite as much on the far left-hand side of the chart. Much would have depended on the trader's outlook, trade allocation, and other such matters. It is beta weighting the position against the SPX that allows the trader to experiment and determine how many SPY options to buy.

What exactly is beta-weighting?

I don't want reading this article to require a degree in mathematics. I want to state it as simply as possible, so my definition will cause you mathematicians and statisticians to roll your eyes. First, I'll provide an official explanation from Investopedia, describing it as a "measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole."

The beta of a security measures how well its behavior correlates to another security. Most often, stock prices are weighted against either the SPX, the RUT or some other important index, depending on whether we're speaking of a big cap, small cap or other type of stock. A beta higher than 1 means that the stock being weighted is more volatile than the security against which it's being weighted.

How is the beta determined? A search of the Internet will send traders to sites that help set up Excel spreadsheets to calculate beta. Most of us are happy to rely on our trading platforms to automatically beta weight our strategy or portfolio when we're seeking beta weighting. That's probably just fine when we're beta weighting SPX/SPY, Dow/DIA, or RUT/IWM combination trades.

However, a little more detailed look at how beta weighting is calculated might highlight some risks if traders stray too far away from those kinds of combinations. I'll draw from the description offered by a trading group member studying with Dan Sheridan to simplify the explanation. He discovered that Yahoo! Finance uses the monthly returns of the last three years, then maps those returns onto the monthly return of the index against which that underlying is being beta weighted. Then regression analysis is used to calculate a best-fit trendline. The slope of that trendline constitutes the beta. Remember back from junior high or middle school geometry when you learned to calculate a slope? A slope of one means that for every unit the line moves horizontally, to the right, it also moves a unit vertically, headed up. The movement along the right axis is matched by the movement along the upper axis.

However, let's think a moment. I'm sure anyone who has traded even a number of months has experienced some weeks when prices zigzag violently but, by the end of the month, end up pretty much where they started. If you just look at the difference month over month, you're not going to find much. Does that really describe what trading was like that month? Was it a calm month when prices marched along a straight line? Hardly.

Beta can be like that, too. That best-fit trendline is seeking the most contact points, if you will, but the mapped points may be all over the place on that graph. That means that while we're pretty safe beta weighting our SPX/SPY combo trades, we may not be as safe beta weighting a portfolio composed of a combination of SPY shares or options and Banco Santander (STD) shares and options. The slope of the best-fit line might not be telling the whole story.

In fact, there's another number, coefficient of determination or r-squared, that tells you how reliable the beta you've found or calculated is. In my own trading, I haven't had to worry about beta-weighting such a diverse portfolio because the beta weighting I'm doing is against underlyings and indices that do have a strong correlation. If you're doing otherwise, perhaps it's time for you to search for some of those sites that tell you how to calculate beta and the coefficient of determination for yourself.

The point of these two articles has been that, within reason, you can sometimes use beta weighting to help you determine how to hedge your strategy or portfolio.

I wanted to add a last note that has nothing to do with the topic of this article but much to do with options trading. As many of us have been anticipating and as I have warned as a possibility in my Monday Wraps, the markets have weakened. Because the markets were behaving in concordance with a negative outcome and we had such important economic releases the end of the week, I elected to close out my JUN trade Wednesday, locking in the profits I had at that time. As it turned out, that well-hedged trade would have been okay, but it wouldn't have been okay if markets had truly fallen apart. I am waiting out the next few trading days before I decide about putting on my JUL trade. I will probably trade, but I may keep my trade small and I certainly will keep it well hedged both directions. Rabid but probably temporary relief rallies are now as much a risk as a true capitulation day. I'm not saying that you shouldn't trade, but I am saying that you should be extra cautious about the risks you take on over the next couple of weeks, and perhaps you shouldn't trade live if you're a newbie. This month is not the month to size up considerably in a new trade. Good luck.