Best way to hedge a long Trade, Options ect....

[monkey180]

Hi,

I was wondering on the best way to hedge a trade.

Please look at the example, of a very neat break out and retest.

But I have got stuck looking at all the options to hedge it.


So... Lets say I take the trade normally, with a stop loss, that has a value in my account of 100 pounds.

I could then sell an OTM out option to get 100 pounds in premium, so the worst case is that the trade breaks even.

However what if the stock gaps, and then I have to put the stock, if it gas below the Strike

Are there any other methods I could use with options, to hedge for that eventually? Maybe buy a put that would make up for the loss of putting the stock ect.. or shorting the stock too ect...

Going round in circles a bit, would a bear credit spread held this?

Basically looking for way using, shorting / options trading that would make my worst case in the trade of break even.

Selling puts would cover this, but is the great What If - like the shock gas way below.

Thanks
Freddie

 

[monkey180]

Also if the stock sells heavily, and then I would choose to Buy to Close the option before it hit the strike, but that would incur a loss because I would have to buy it back at a higher price.

But that could even make the 1st 100 loss larger, would have that, and then the loss of closing my put out.

 

[ACstudio]

Just manage the Deltas. If you own 100 shares of stock you have 100 Deltas of risk...if you own 20 shares of stock you have 20 Deltas of risk. If you sell a 1 lot of calls at the .30 Delta you've taken off 30 Deltas of risk. If buy a put at the -.30 Delta you again take off .30 Deltas of risk.
When you hedge off risk you are also limiting your gains.

How many calls are you selling to generate 100 in credit vs 100 worth of stock?

What are you buying to close if the sock sells off? If it's the call then it would make money.

If you sell 1 call against every 100 shares you are creating a covered call...which is basically the same as a naked short put. However the capital requirements might be different so sometimes it makes sense to just sell a put to go long (just depends on your account and the nature of the underlying)....then you can sell calls to take off risk or roll for more duration when tested.

Selling puts is bullish...you would only be adding to the risk of long stock.

Selling a call spread to be bearish is just what it is....works best if volatility is high but will reduce the Deltas by whatever it is. Example if you sell a call spread with strikes at Deltas .40 and .20 you will only be taking off 20 deltas of risk.

 

[options-george]

Hi Monkey,
I will try to answer your question.

If you are long in the underlying instrument (which it seems you are) and are in profit and want to protect the position then you would normally BUY (not sell) a put option. If the underlying falls in price then the loss in the underlying will be offset by the gain in the put option value.
If the underlying rises in price then the additional gain in the underlying will reduce by the amount you paid for the premium.

This is actually not very straight forward. You would need to consider what expiration date and what strike price you want to use - and would need to be able to estimate the various profit/loss scenarios for both the put option and the underlying, for various price levels of the underlying. You also need to understand the time decay and volatility aspects of any option you buy (or sell).
Finally transaction costs on options tend to be higher.

A potentially simpler way would be to manage your stop loss on the underlying position, or to close the position of the underlying and then use part of the profit to buy a call option - to allow to gain more if the underlying continues to rise, but to have a max loss equal to the premium you paid for the call option.

Hope that helps.

P.S. On the whole I believe that retail traders vastly oversimplify the idea of trading in options.

 

[monkey180]

Hi, thanks to you both for taking the time to write such lengthy replies.

I think I have found a technical strategy that I only want to focus, on. Very neat range breakouts, and then also trade the retest if that happens.

My hedging idea was to simply short the SP / Sector ETF to for example 1/3 of the max loss of the trade.

However since learning more about options, I would like to use those to manage risk, I have been dabbling for a while, and still cannot get myself away from watching the real time P/L all the tine, hence options, if I buy a call then I know max loss, but time decay, hence discovered selling puts, with no time decay. But then what if I combined a normal trade with options.

What would be the best way to manage say a channel break out retest?

From what you have said, trading long and selling a put are 2 long positions, so not very much hedged.

Say I take the trade normally, at the retest, and then sell a deep OTM call as well? If it goes down, loss is covered by, buying to close the call at a profit.

However if it goes, up lots there is a risk the call I sold will be exercised, however the long trade would have made up for that loss.

So best case would be, the long trade wins, but the stock does not go so high that my call is exercised?

What other ways might I use options to bring about this more risk free approach to taking a trade?

Thanks
Freddie

 

[options-george]

Selling a OTM call option - this is referred to as a "covered call strategy" and is used by many traders. The downside is that the more OTM the option is, the less premium you will collect for it. The less OTM option is, the more premium you will receive, but the higher chance that it will become ITM by expiration date and be exercised against you. If you analyse it carefully, you will find that being long the stock and having a sold a call is actually the same risk profile as having sold a naked put option - because you have limited profit potential and unlimited loss potential.

In my view, the simplest way of using options to manage your risk of the long stock position are what I pointed out in my original reply.

Also I want to suggest that the usage of options may be more complicated than you expect, so do tread with caution

Good luck!

 

[monkey180]

I see so the more OTM it is, the more I have to sell, and then if the stock does hit the strike, as I had to sell more contracts the bigger the loss.

How would selling a straddle / strangle on this type of technical trade do?

I mean by selling an OTM put and also an OTM call, if none strikes are hit then keep both premium, but if one hits strike, would that loss be covered by the gain of the other?

Thanks

 

[options-george]

I see so the more OTM it is, the more I have to sell, and then if the stock does hit the strike, as I had to sell more contracts the bigger the loss.

How would selling a straddle / strangle on this type of technical trade do?

I mean by selling an OTM put and also an OTM call, if none strikes are hit then keep both premium, but if one hits strike, would that loss be covered by the gain of the other?

Thanks

Yes, the more OTM the call option, the more contracts you would need to sell in order to bring in a certain amount of premium. However generally the broker will only let you sell the quantity of call options that corresponds to your long position in the underlying. If the stock does hit the strike then you will not make a loss, because the loss in the option contract will be offset by the gain in your long position.

Selling a straddle on strangle - only one of the legs (i.e. either the puts or the calls) will expire in the money, the other will expire worthless. The call portion of the strangle/straddle sets up another covered call trade, however you will be collecting a bit more premium from having sold puts and calls at the same time.

This works out ok if the underlying rallies. However if the underlying falls then you will lose on your long position in the underlying plus have unlimited loss potential on your short puts.

The loss on the short put option is not going to be offset by the premium you collected for selling the call. The loss could be significant.

Again, a broker is unlikely to let you sell straddles or strangles.

This is not a strategy I would recommend. The only people that generally sell strangles or straddles are (or at least should be) professionals who do so because they believe that implied volatility (which drives the time value component of options) will fall.

If you want to pursue this area further I would suggest to start playing around with various risk graphs so that you understand how various option positions can play out at expiration. You can also build this yourself in Excel. You can then add long or short positions in the underlying. I built a simple spreadsheet like that when i was working with a market maker a few years ago, and it helped me a lot to understand what's going on.

Hope that helps.

 

[monkey180]

Thanks.

But coming back to the trade example I uploaded, in terms of collecting premium to offset loss of the trade.

Say I took the restest of that range as a trade with 100 max loss, and then I sold OTM call options way above the point where the stock started to sell back to the test level.

If the stock gaps down, that's OK because the calls would make a profit because I could sell to close them, to offset the loss of the traade

If the stock goes up but not to the striks of the calls, I win the trade and keep all the premium, so long as it expires under the strike.

If the stock goes alot higher, then the win from the trade will offset the costs of the calls being exercised.

In terms of the broker, I could just use different accounts, one to take the trade, and one to sell the calls.

Could I explore collection premium on more very liquid, low volatile assets linked to the trade,

e.g Take the trade and sell calls on the SP / Sector ETF, so lets say the SP was at 2000 as the time of the trade, sell calls at 2300 - 2400, very low chance of them being exercised.

 

[monkey180]

I have been looking into loads of methods of technical trading, and this is the one I want to concentrate on, very clear visual of a break out and retest, so just exploring best way to trade and hedge.

I would like to think that simple risk management would make this a winnable strategy anyway - take them as a nomral trade, 60% win with a 3:1 win to risk ratio.

Am looking how to expand that a little, to use selling premium to offset the risk of the trade not winning, and to stop large draw downs.

I like to imagine before taking trade, I like to imagine that the SP will shed 200 points tomorrow, what is the worst case for my trade? Well it would hit my stop loss - but where is the other income / trade to offset that? Most fear is of the stop gapping, as I use leverage CFD's.

If you were taking that trade - what methods may you use to ease the fear of the worst happens and getting caught in a heavy market sell off? Apart from the normal account management e.g, only risk 1% of account, aiming for 3/1 ect.....

I have noticed that very clear breakouts / retests with a bit of volume behind them can swim against a selling market, maybe my original method was the best, take the trade, and then short the SP / Sector ETF, that would square the fear of a market sell off. Then my hedge would have won and also the strong trade would have won also, you win some you loose some..

 

[options-george]

Thanks.

But coming back to the trade example I uploaded, in terms of collecting premium to offset loss of the trade.

Say I took the restest of that range as a trade with 100 max loss, and then I sold OTM call options way above the point where the stock started to sell back to the test level.

If the stock gaps down, that's OK because the calls would make a profit because I could sell to close them, to offset the loss of the traade

If the stock goes up but not to the striks of the calls, I win the trade and keep all the premium, so long as it expires under the strike.

If the stock goes alot higher, then the win from the trade will offset the costs of the calls being exercised.

In terms of the broker, I could just use different accounts, one to take the trade, and one to sell the calls.

Could I explore collection premium on more very liquid, low volatile assets linked to the trade,

e.g Take the trade and sell calls on the SP / Sector ETF, so lets say the SP was at 2000 as the time of the trade, sell calls at 2300 - 2400, very low chance of them being exercised.

You got all the points more or less correct, so you are definitely starting to understand some of the in's and out's. So you have basically described most of the aspects of a "covered call" trade. Great!

In terms of specific example. You would pretty much get zero premium for options that are so far out of the money - e.g. 2300 calls when the index is at 2000. Remember that you want to sell options that expire in the near future (say 30 days away) because time decay is greatest near the expiration day. So selling one month calls that are 300 point out of the money are not going to be worth anything.

I'd be happy to help you along a bit more with options - but making the posts is not the most efficient way I think. I see you are in the UK, in case you are in London, you could pop around to the office for a coffee and I can talk you through some of the aspects. It's a fun and interesting area for me, even though I don't trade any options at the moment.

Though on the whole I do not think that there's a lot of money to be made from doing covered calls.

 

[monkey180]

Hi, sure thanks not in London, but if down there thanks for the offer, yes I think it is not good bouncing ideas around in your own head, especially when speculating, good to have another to bounce ideas off.

I was wondering, if sold a vertical put on the SP 500, that reduces the margin needed greatly, can you then make the short put side of the spread naked?

If you can other than the butterfly, is that the best way to sell puts with least amount of margin needed?

Thanks