The art of hedging allows you to protect your portfolio (or position) against an unforeseen event.
However, if you OVER-hedge, it could end up being more than just insurance cost…
It could end up eating away at your profits.
Traders fall into one of two camps – little to no hedge on or hedge everything.
So let me show you a third way to think about it…
Shortly I’ll explain to you one of my favorite hedging techniques…
You can see how I applied it to this Weekly Money Multiplier trade for ZS.
While there isn’t a right way or a wrong way to hedge, you need to understand the tradeoff.
So, let’s walk through some basic hedging strategies and what you gain and lose from each.
Also known as ‘theta’ decay, time decay happens when you buy or sell options. All things being equal, options will lose value over time.
When buy options, that works against you. For sellers, it’s great.
Option time decay works in an exponential fashion as this graph shows.
Buying options gives me leverage. For lower amounts of capital, I get to control more shares of stock. That lets me profit off of stock movements with much less money up front.
The tradeoff is that every day I hold that option it loses value. So I need to be right and fast.
Selling options works the exact opposite way. I want the stock to go nowhere or in the opposite direction of the contract I sold. The most money I can make is when time runs out and the option contract expires worthless.
As a long option buyer, I experience time decay as a negative. To offset that, I will sell put credit spreads (bullish bets) for some of my trades.
A put credit spread has positive theta, meaning that every day that goes by, the premium loses money and I get closer to my maximum profit.
However, a put credit spread, or even a naked short put option, has a limited profit potential. By giving up profit potential, I negate the effects of time decay on my other long option trades.
Directional risk is known as ‘delta.’ Many traders will create delta-neutral portfolios that nullify the effects of price movement, instead of focusing on time and implied volatility decay.
When you buy a call option that is at-the-money (meaning the call option strike price is the same as the current stock price), your delta is 0.5 (or -0.5 for a put option). That means I control the equivalent of 0.5 x 100 shares = 50 shares of stock per contract.
However, the delta number changes the further I go from the current stock price.
You can see the relationship in this graph here.
If I want to offset my directional risk with these options, the easiest way is to buy or sell the underlying stock.
For example, if I own a call contract with a 0.5 delta, selling 50 shares of that stock short will completely neutralize any price movement.
You may ask why anyone would want to do this.
Well, option sellers who sell credit spreads will often do this in order to remove directional risk. Instead, they try to make money off of time and volatility decay.
Here’s the real simple table to help you understand how to offset the trade.
Let’s say I had a long call option in Stitch Fix (SFIX), one of my favorite momentum stocks. I want to hold this stock for about a week. However, that will cost me $50 in time decay.
My solution would be to sell a credit spread on this stock or a similar stock. Ideally, I would choose a put credit spread.
A put credit spread is a bullish bet that still makes me a net seller of the option. Although it has limited profit potential, it gains money through time decay.
So, if one option for my SFIX long call has a theta of -10, then I want to sell enough put credit spreads to give me +10 theta. That way the two completely cancel each other out.
In this case, I’m still bullish SFIX and profit from it going up. However, I traded off more profit potential for eliminating the time decay component of my trading.
This type of strategy development can take time.
However, one way to short-circuit that is by learning from someone who can teach you the ropes.
That’s why I created Weekly Money Multiplier. Here, you get a chance to learn from my experience and see how I put together my favorite option trades.
I am not looking forward to Friday.
Don’t get me wrong, I love to celebrate holidays, and especially Independence Day.
BUT I LOVE TRADING!
And the weekends are already agony as it is.
However, I’m not about to spend my 4-day week pouting.
Instead, I’m charting a course to the land of profitability.
All of that starts with picking out my favorite charts for the week.
We’re all friends here right?
I figure it’s ok for me to tell you my top three ideas for the week.
Just make sure you keep them to yourself…
Pandemic headlines ripped through the front pages last week. We saw states that lead the economic reopening come to a screeching halt as new positive cases grew.
That led to a dramatic pullback in stocks, hitting some of the biggest winners like Amazon (AMZN) and Apple (AAPL). The carnage was widespread, bodies littering the ground.
But I think I found a stock that not only isn’t on life support, but could break out to new highs.
I give you one of my favorite momentum names – Etsy.
Shares of the online craft marketplace steadily rose alongside other stay-at-home plays the past few months. Incredibly, they more than tripled off their recent lows, and continue to make all-time highs.
This is my sweet spot.
ETSY 78-Minute Chart
LottoX members know that I trade momentum stocks, especially ones reaching new highs. I’ve never found luck in trying to pick off the top or bottom.
Instead, I make my bones following the trend.
And that’s where my TPS Setup comes in, which is present in this chart.
Three components make up my TPS Setup:
Going back to Etsy’s chart, the white arrow highlights the clear uptrend the stock followed for the better part of a month.
Using the tops and bottoms of the candlesticks, the white lines draw a chart consolidation pattern. It illustrates price trading in a narrowing channel.
Lastly, the red dots at the bottom signal a squeeze, when the Bollinger Bands move inside the Keltner channel. Green dots signal when the energy is released.
Working off the 78-minute chart, I plan for the trade to complete within the week. However, the shortened trading week might throw a wrench in things.
Rather than trading options expiring this week, I might instead choose to take ones for the following week.
Whatever I decide, I’ll be sure to draw out my logic and plans for LottoX members.
Not too many stocks rise from the dead the way Overstock has. Yet, shares made a remarkable comeback after languishing below $10 and surviving a controversial CEO.
What attracted me to the stock this week is another…you guessed it…TPS Setup.
OTSK 78-Minute Chart
In this 78-minute chart, shares made a quick jump to end the week. That created the uptrend and the start of the consolidation pattern.
Now, I hadn’t paid too much attention to the stock because it had a lot of negative momentum. You can see that at the bottom histogram in the white box where the bars dip slightly below the centerline.
Recently, momentum shifted higher at the same time the rest of the market struggled. This is called relative strength and tells me enough buyers were interested to fend off a broader market decline.
Lastly, I bring your attention to a tech stock that’s traded extremely well over the last few months.
Mongo DB benefited not just form a solid uptrend in the equity but a broader lift in the Nasdaq technology stocks as well.
With another TPS Setup popping up on this chart, I want to point out something different.
MDB 78-Minute Chart
MDB ended last week close to the highs. That doesn’t leave a great entry for me since it’s very close to where I would set my target.
Ideally, I want to see the stock pull back somewhere between the 8 and 21-period exponential moving average. Otherwise, I might reduce my starting position size.
I can’t tell you which of these trades I will take for certain and how they’ll all pan out.
What I can tell you is that the best way to find out what I do is to catch me in LottoX, where my portfolio of trades is streamed live for members.
How many times have you found the ‘perfect’ setup only to watch it fail?
It’s one of the most frustrating parts of trading – watching the ideal trade and your confidence shatter at once.
Why does this happen, even after we’ve seen that setup work dozens of times?
One word – Context.
While I talk about context a lot, today I want to explain WHY it matters.
Context isn’t a simple black or white analysis of the stock or the market. That’s why you don’t find too many algos that swing trade.
And it’s what separates good traders from great traders.
With some common sense and practice, you can learn to incorporate it into your trading.
Typically, someone gets comfortable with the 15-minute, or hourly chart. They develop tunnel vision and don’t consider anything else.
Looking at different time frames helps me see the larger trends behind a stock. It also shows me where important support and resistance exist.
Take the SPY for example.
SPY Hourly Chart
If I was looking at an intraday 5-minute or 15-minute chart, I would never have seen the 200-period moving average on the hourly chart. That important piece of information would have escaped me and I would have missed the bottom.
Now, there is a limit to how far up I go. If I’m trading intraday, there isn’t much reason to go out to a weekly or monthly chart if I’m on the 5-minute. The two aren’t close enough to matter.
Part of knowing which timeframes to look at comes from experience in trading and with watching that stock.
How many times have you seen Apple report earnings, rocket higher afterhours, and pull Facebook along the next day?
Facebook, Amazon, Apple, Netflix…these are some of the largest companies that make up the Nasdaq 100 (QQQ) ETF. In fact, they’re a large part of the S&P 500 as well.
Even though the companies’ stocks trade individually, many traders tie them together. Whether its a hedge fund strategy or an ETF that constantly rebalances, like stocks will trade together.
When markets start to crash, it takes nearly everything with it.
Huge rallies often raise all boats.
With every stock, I always look at how it’s performing compared to the rest of the market and its sector.
Here are a few questions I like to ask:
For swing trades that last several weeks, while I must see a strong trend in the stock, timing it with a broader market move in the same direction gives it an extra boost.
The goal with all of this is to look at the bigger picture, starting with the stock’s sector and then branching out to the overall market.
However, you don’t want to let unrelated stocks influence your decision. The way energy stocks trade on any given day probably isn’t related to technology stocks.
We know there’s always an exception to the rule. Quite often, I look to play these uncorrelated stocks for this very reason.
Uncorrelated stocks tend to trade independently of the market. An extreme example would be penny stock biotech companies.
Typically, more recent IPOS (companies that went public) or momentum stocks will trade on their own, irrespective of the broader market.
A good example would be Nikola (NKLA). This company came to the market in a slightly different way. However, the internal mechanics of the shares and traders cause the stock to skyrocket even though they have yet to earn a single dollar.
NKLA Hourly Chart
I find these niche stocks a bit easier to trade since I don’t have to worry about the bigger picture. It lets me focus on the chart at hand without worrying about where the Dow is.
Everyone talks about the Coronavirus and its economic implications day after day, and for good reason. Certain parts of the economy contracted more than others.
While I don’t need to understand the nuances of every sector, grasping the broad storylines certainly helps.
You can see this in action with the resilience of Telodoc (TDOC) and Zoom (ZM) during the market selloff. Despite most stocks cratering, these two regularly pushed higher.
Money decided this was the place to hide; that they would benefit from the current climate.
The storylines don’t need to be these long, drawn-out ideas. Simple ones work perfectly fine.
If I looked at the current markets’ charts without any context, I would bet on a bull run.
But, analyzing all the pieces, I actually bought puts on the small caps index recently.
In my LottoX morning emails, I detail why I’m thinking about the market his way and how I came to my current trading decisions.
I want people to understand why I take the trades I do and teach them to become better traders themselves.
And you can take advantage of this education, starting with my upcoming webinar.
Here you’ll learn all about LottoX and what to expect.