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.
Hedging directional risk
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.
A practical example
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.
Putting it all together
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.