From the May 01, 2007 issue of Futures Magazine • Subscribe!

Embracing the option hedge

After presenting several trading techniques in the context of two short-option strategies in “Understanding options,” April 2007, here we’ll expand our resources for managing the trade after it is in place.

A common theme of many options positions is the possibility, however remote, of unlimited loss. One simple technique to hedge against such a scenario is to buy the option back at the sign of trouble. However, in most situations doing this would put a big hole in your trading account. There are other ways to hedge this risk if you are willing to incorporate more advanced strategies into your trading program.

FROM ONE MAKE MANY

Imagine a situation where you sold a naked call option expecting the market not to move too far before it expires. However, the market did move up and so did the option premiums. In fact, option premiums zoomed, making the buyback scenario quite expensive and not that appealing.

The next simplest solution is to buy some protection. In this case, that can be accomplished by buying a higher strike call. Losses may incur, but this would guarantee that you would still be trading come tomorrow. “Buy protection” in this case is option trader parlance for buying an option one or more strikes higher for calls, or one or more strikes lower for puts. Comparing this to a futures trade, this would be analogous to placing a stop loss. The most you can lose is the difference between the strikes.

Once you have decided that this is the most appropriate course to follow, you have to decide how much to spend for the protection. The further away you go, the lower the cost but the higher the potential loss. The balance you want to strike depends on the circumstance and personal risk tolerance. If you have a low tolerance for risk, due to either your account size or personality, then this is pretty much your only other choice aside from buying the option back. This is a reasonable route, especially if there is still a fair amount of time left and the option premiums haven’t ballooned due to the volatility. A good rule of thumb is to look to spend about the same amount that was brought in with the original option sold.

The spread option begs the question of why you would not do the spread from the beginning. There are many strategies that sell credit bear spreads (for calls) and credit bull spreads (for puts).

However, the problem with the spreads is that although they do cap your absolute risk, they actually increase the risk of ending with a loss. In other words, spread positions cap your price risk but increase the time risk. The time risk increases because, normally, the short option positions are exited by buying them back once either the time or underlying value decreases, and there is only a fraction left at the price. This means that either the market has stayed about the same but some time has passed, or the market has moved favorably to your position.

However, most of the time spread positions are kept until expiration because exiting them would consume the profit. For the observant reader, it may have become obvious that the time risk increases because the market has more time to make an adverse move. Additionally, open positions consume margin and because the spread positions are open longer, they are a less efficient use of the trading account equity.

PROTECTING GOLD OPTIONS

To illustrate a protective spread position, we can take a closer look at a recent gold trade. A good example can be found in the gold options market, starting back in October 2005 (see “Golden parachute,” below).

On Sept. 15, 2005, a 475 strike gold call was sold with about 40 days until expiration. The premium pocketed was about $300. At the time, gold was oscillating in a range, topping out at about $460. By Oct. 10, there was trouble looming, as the price had clearly broken through a resistance around $475. The price pattern was conducive for the price to move quite a bit higher, with 500 as a reasonable target before expiration. Although option volatility had increased it was still fairly low.

At this time, a good move was to buy a 490 call. The cost was about $300, and it would limit the loss to $1,500. As anticipated, the market turned around and continued with the consolidation pattern. At expiration, it was just near the option strike.

In hindsight, it would have been better for the bottom line to have done nothing; however, buying the call allowed the trader to control the risk, meaning that no matter how much the market went against the original position, the trader would live to trade another day.

DOING THE UNEXPECTED

There’s another option for dealing with the downside. You actually can embrace additional risk and increase exposure. Instead of buying a higher strike (or lower for put options), sell it. Initially, this sounds like driving off the proverbial cliff because you will be increasing the exposure and risk to the same adverse market move.

However, this is where the volatility comes into play. Volatility tends to be cyclical, and high volatility periods are regularly followed by low volatility periods. If volatility has increased substantially, then there is an excellent chance of seeing some price correction, or at least price leveling. The increased volatility also provides an excellent opportunity to sell high-priced, out-of-the-money options. Quite often, a substantial amount of premium can be brought in to help cover a potential loss incurred with the originally sold option.

Needless to say, despite its reliance on volatility (one of the most reliable variables in option prices), this course is quite risky. You need to:

Understand the trading account limits. This action is highly inappropriate if the account is low on excess equity. In other words, most of the equity on the account has been consumed by the existing positions and there is little to spare.

Measure implied volatility. Nearby, out-of-the-money option prices imply volatility — they are priced to the volatility expected by market participants. Implied volatility in normal market conditions is about the same as standard volatility of the underlying. However, on strong price moves, the implied volatility tends to zoom way above it. Once implied volatility has spiked upward, at least by double, then price correction or leveling normally occurs.

For illustration, we can look at a couple of silver trades. In one example, this strategy worked. In the other, it created some real nail-biting moments.

On Nov. 16, we sold an 8.75 call options with about 40 days until expiration for $425. Silver had been range bound and moved higher eight days in the row. It is symptomatic for silver to move in cycles where it moves higher inch by inch and then corrects violently. It also has a tendency to trade in ranges that top out around $8.00.

After a relentless march higher by silver on Dec. 9, another call option was sold. This time, the strike was 9.50 and it brought in $450 of premium. The hope was to cover a possible loss with the 8.75 call. Although there were only two weeks left, we were able to sell an option about as far away as before for about the same amount. This is what increased volatility does to option premiums.

The market spiked higher the next morning and then came crashing down (see “Right on cue,” below).

On Dec. 20, the 8.75 call could have been bought back for $100, while the 9.50 call was left to expire worthless. The extra option sold in this case worked out just fine and generated extra profit, but adding to a losing position can be dangerous.

These trades don’t always work out so merrily. A 12.50 silver call was sold on March 24 for $300, with about 35 days until expiration. At that time, silver’s average monthly move was less than $1.00. While silver had been in a continuous uptrend, some retracement and leveling was expected, as per implied volatility readings.

By April 18, however, silver had advanced substantially, by more than $3.00, within three weeks, about a 30% move. Implied volatility readings were hitting the roof and were strongly indicative of a correction. To hedge the possible loss with the 12.50 call, another call was sold with a close-to-the-money strike of 13.50 on April 18 for $2,000.

On April 19, the market advanced even further. As it always does on days like this, it seemed like the sky was the limit. On April 20, the correction hit. Silver crashed down so rapidly that trading on the New York Mercantile Exchange was halted several times during the trading day (see “Tarnished trade,” left). By the end of the day, silver was back down to about $12.50.

The contract expired just below $13.00 and the 12.50 call was assigned, but the 13.50 call expired worthless. For about a day, it was a precarious situation. There was no protection to the upside and the exposure of the original position was increased.

As should be clear with these examples, managing option positions is not an exact science. It also requires an understanding of the effects of time decay and volatility. And, sometimes, you have to be willing to risk more money to protect that which you already have placed on the table.

Next month, we look at techniques for creating strangles and straddles and discuss when they should, and shouldn’t, be used.

Robert Steelman is a principal at Theseus Trading www.theseustrading.com. He is a self-taught trader specializing in mechanical systems and option writing. E-mail him at robert@theseustrading.com.

Comments
comments powered by Disqus