In the previous two parts of this series on managing position risk in options, we have presented some fairly simple, but effective, techniques for hedging. These included simply exiting the position, buying protection using a spread trade and increasing exposure by selling expensive near-the-money options.
While these techniques provide a formidable portfolio of tools for hedging, there are even more ways you can protect your profits or trim your losses. One approach is an extension of the basic spread positions. Known as straddles and strangles, these flexible positions can profit in interesting ways.
BUILDING A BRACKET
One choice you have for hedging an option trade going wrong is to take a position on the other side of the market by creating a bracket at the point where your position would be either profitable or break even. You do this by selling the opposite type of option that you had originally sold. For example, if you were originally short a put, then you would sell a call.
This is called either a short straddle or a short strangle. With a straddle, the strikes are the same. With a strangle, the strikes are different. Both positions achieve their highest profit when both the call and put expire worthless. Needless to say, this is also a fairly risky action to take because, theoretically, you would be facing nearly unlimited losses on either side of the market.
The key to a straddle or strangle is to know when it would be applicable. The proper time for this strategy is when the market is trending and does not show any signs of correction but rather looks to consolidate.
Analyzing the reasons behind the move can provide some clues. Moves fueled by clear fundamental changes in demand or supply generally do not correct via opposite price moves but instead level at certain points. For example, if the demand for a certain commodity is expected to increase without an adequate increase in supply, then most likely the price will eventually consolidate rather than plunge back toward lower levels.
A market that provided a somewhat easy-to-predict opportunity for a bracket trade was the corn rally during the fall of 2006. There was a genuine concern for supply in the face of higher corn-based ethanol production.
Another instigator for an upward trend is the risk premium of a certain commodity. For example, the entire energy sector has had a substantial risk premium embedded in the market price since the hurricanes in the summer of 2005, and due to the political tensions in the Persian Gulf region because of supply concerns.
As the hurricane season of 2006 passed without incident and the war with Iraq and other political tensions in the Middle East didn’t produce significant supply interruptions, the risk premium bled out of the market and the price of crude oil declined substantially.
The critical question when placing a straddle or strangle is the strike of the new option. You need to decide how much premium to bring in for the risk assumed.
The art of this trade is balancing the width of the bracket with the premium intake; you want to create a bracket wide enough for the time until expiration and at the same time bring in enough premium to cover the potential swings.
No matter how you structure this trade, however, this position is usually a nail biter regardless of the direction the price moves. The following are important points to keep in mind:
• The more time that is left until expiration, the wider the bracket should be. Analyze how much the market moves, on average, within the length of the period left until expiration for the original option. The average true range indicator, or a similar measure of volatility can be helpful here.
• Your account size. Nothing is possible without the funds to do it. Your account needs to be funded accordingly so that the new position will not likely invoke a margin call.
• You need to be willing to accept a higher risk in the name of saving the original position.
Sometimes, due to the market bias, options on the other side do not reflect the actual volatility and are relatively cheap. This happens most often with the puts upon an advancing market. In a situation like this, creating a straddle or strangle is not appropriate.
“Crude slide” (below) shows how a straddle was used to manage a short put trade placed a bit premature in anticipation of prices bottoming out.
UNDERLYING RESOLUTION
If creating a straddle or strangle is inappropriate, you can always take a position with the underlying, thus creating a covered call or covered put position.
In most cases, however, this is the least favorable choice because the margin for error is small.
For example, if you are short a call, to allay your risk you would need to go long on the underlying. You are going to be fine as long as the market keeps going up or stabilizes around your price. However, quite often it might already be stretched to the upside and the corrective move could prove to be powerful.
Should the market correct below where you went long and below the strike price of your short call position, then you’ll find yourself with the losing futures position covering exactly nothing. Should you exit and the market moves up again, you have taken a loss and are back to the need of hedging the short call position.
Consequently, the long futures position should be kept until you either exit the call or until expiration.
Because market moves are difficult to predict, the chance of a loss has increased substantially. This route should be taken only if the option market is illiquid and you can’t resort to any other corrective strategies.
There are other factors to keep in mind when you are managing an option position with the underlying. The longer you can postpone taking this action, the better. The reason is the potential for error decreases as the option approaches expiration. Patience does pay off.
Also, if the market moves sharply to the benefit of the underlying, then you should buy insurance.
In other words, if you are protecting a short call with the long futures position, you would buy a cheap put after the market has made a strong move up. You might be able to leg yourself into a favorable position where the loss will be limited and there is still some chance of a profit.
VOLATILITY MATTERS
As with most things, dealing with a poor position is easier done if it is pre-empted in the first place. A good way to get yourself on the right side of the market is to understand the role of volatility and how to measure it. Options are best sold after a spike in volatility. Volatility increases the premium, allowing the seller to sell either further out-of-the-money strikes or nearer-the-money strikes at substantially higher premium. Because volatility is cyclical, the odds of the trade being successful are higher.
But measuring volatility correctly is the key. As mentioned, it tends to be very cyclical — high volatility periods are generally followed by low volatility periods and vice versa. On the price charts, high volatility manifests as large price moves.
Low volatility periods often appear as consolidation on the price chart where the price oscillates within a certain range.
There is no certainty regarding the start or end of the cycles. But to visualize the ebb and flow of volatility, we can turn to Bollinger bands. Bollinger bands are calculated using some multiple of the standard deviation added to and subtracted from the simple moving average.
The volatility is low when the bands are narrow and high when the bands spread themselves wide open. “Corn on the move” (below) shows what Bollinger bands look like on the May 2007 corn futures chart.
While indicators such as Bollinger bands and average true range are important measures of market volatility, there is an even more important volatility reading: implied volatility.
Implied volatility is calculated using near-the-money options volatility and in essence reflects the volatility anticipated by option traders.
However, there is no need to calculate these figures on your own. They are available in the public domain.
Sources include www.crbtrader.com, www.optionetics.com and the exchanges themselves.
Options are powerful vehicles for taking advantage of market moves. However, the market doesn’t always move as you expected. It’s easy to make money when things go your way.
Managing positions well during the bad times is the mark of a successful trader. The more tools you have at your disposal, and how well you know how to use them, the better your chance of achieving that success.
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. Sandrina Mayela, is a commodity trading advisor and an options trading specialist at Theseus Trading. Email her at sandrina@theseustrading.com.
