Swing trading meets risk hedging

September 26, 2016 09:00 AM

Options traders struggle with the conflict between conservative hedging strategies and shorter-term speculation and swing trading. One strategy reconciles these two conflicting purposes in a way that combines swing trading with conservative risk hedging.

As a starting point in any trading program, selecting fundamentally strong companies makes good sense. It also translates to lower risks in options strategies. Looking for companies with exceptional dividend yield is one key indicator. Chevron (CVX) has increased its dividend for the past 10 years, and currently yields 4.20%. Another indicator is the debt capitalization ratio, which CVX reported at 17.8 as of the latest fiscal year. As of July 29, 2016, the company’s stock price was $101.93 per share.

The options strategy worth considering to combine conservative hedging with current income is the installment strategy. This involves buying one LEAPS (Long-Term Equity AnticiPation Securities) option and paying for it with a series of short option sales. There are two varieties.

The contingent purchase strategy is designed for those wanting to buy shares in the future, but who are interested in freezing the price per share at current levels. With CVX trading at $101.93 per share, look at the June 2017 options (expiring in 322 days). The price per share is frozen by purchasing a 100 call at the ask price of 8.10. For $810 plus trading costs, you have a choice by next June: Exercise the option and buy 100 shares at $100 per share, or sell the option and take profits. 

These choices are profitable if the stock price has moved up. If the stock price has declined, you lose nothing. That’s because the $810 paid for the stock is paid for with a series of short-term short calls and puts. The short calls are covered by the later-expiring long call, and short puts contain the same market risk as a covered call. For example, as of July 29, the weekly (expiring Aug. 5) 102 call was bid at 0.98. After deducting closing costs of $9, the net of this is about $89. Or by selling a 102 put, the bid is 1.05 (or a post-trading cost net of $96).

So, in seven days, the net average $100 is likely to expire worthless due to rapid time decay; or exercise can be deferred by rolling forward. Since there are 322 days to expiration, this week-to-week strategy could be repeated 46 times. However, you only need to successfully execute a trade eight times to pay for the long call.

It makes sense to avoid an ex-dividend month when using short calls. These occur in August and November. With short calls, the period immediately before ex-dividend is the most likely timing for early exercise.

The second installment applies if you currently own shares. Buying a long-term put completely eliminates market risk below the strike of the put. For example, a June, 2017, 100 put can be purchased at 9.45 (or $945). This completely removes market risk, assuming you can pay for the long put with a series of short calls (covered by stock) and short puts (with the same market risk as the covered call). For example, the one-week options (expiring Aug. 5) shown in the previous example still works with the installment put, paying for the long position in less than 10 weekly trades, but with 46 weeks to go before the long put’s expiration. 

If either short calls or short puts are exercised, they are covered in both of the installment strategies. However, it makes sense to avoid exercise, meaning selection of out-of-the-money strikes in all cases; and using only the one-week expirations to maximize time decay.

These strategies use options to hedge against market risk, while generating income in a conservative way.

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