Options Theory: How to Hedge a Bear Call
When weakness strikes and downtrends come knockin’, bear call spreads are the go-to strategy for cash flow seeking, high probability loving traders. They boast the profit generating power of naked calls but without all the capital consuming baggage. But what do you do when a well-crafted and expertly placed bear call won’t straighten up and fly right?
You either exit or hedge.
It’s the latter tactic that takes center stage in today’s blog. Let’s make sure we first understanding why hedging a bear call may be beneficial to simply exiting. The virtue of exiting is also its vice. While closing down a bear call run amok ensures you don’t lose any more money, it also denies you any shot at redemption. In all of trading there is perhaps no more frustrating situation than getting stopped out of a trade right before it finally moves in the originally forecasted direction. Veterans call this whipsaw and it’s a curse.
While hedging a losing bear call doesn’t eliminate the potential for additional losses, it does at least leave the door open for the stock to finally cooperate and your loss to eventually turn back into a gain. It’s keeping the dream alive that, not to mention milking time decay, that motivates the proactive trader to hedge an ailing bear call.
Perhaps the most popular strategy to use as a hedge is the bull put spread. Let’s look at an example to illustrate. Tesla Inc recently slipped into a downtrend. Suppose we wanted to capitalize on continued weakness by selling a bear call spread. With TSLA at $312.60, we could sell a January (58 day) $365/$375 bear call spread for $1.01 credit. Here is the initial risk graph with the trade details displayed on the right. Familiarize yourself with the potential risk, reward, and breakeven.
Now, suppose the magic of Elon grips the stock sending prices to the moon. First, TSLA breaches resistance at $327, then $333, then the 50-day moving average gives way at $337. At some point you may decide you want to hedge. Since the bear call is bearish (duh!) we need to add a bullish trade to hedge. To maintain our short premium, positive theta posture, selling a bull put spread is a logical hedge to use. I would stick to the same month (January) and shoot for a similar delta and credit. That means we’d look to sell an OTM bull put where the short put strike has a delta close to the delta of the short call originally sold as part of the bear call. Since we typically sell deltas around 20 or less, then that’s what I’d be looking for on the bull put. We initially received $1.01 on the bear call so I’d look for a similar credit on the bull put I was adding.
Remember, it doesn’t make any sense to add a 5 delta bull put for 20 cents credit to hedge a 15 delta bear call that paid a $1 credit. That will make the resulting position too lopsided.
Suppose when TSLA breaks the $337 resistance level we sell the Jan $290/$280 bull put for $1.80. Doing so morphs our trade into an iron condor, specifically a Jan $280/$290/$365/$375 iron condor for a total net credit of $2.81. The $1.80 captured from the bull put will reduce our upside risk slightly as well as raise the overall breakeven. That means TSLA can now rise a bit further before I lose money at expiration. Perhaps the best way to illustrate is to show an overlay of the original bear call spread risk graph with the new iron condor.
Like the previous illustration, the blue line represents the original bear call spread and the orange line represents the Iron Condor. You may need to study the graphic for a minute to fully grasp the difference between the two positions. Here are the three key impacts of the hedge:
First, the upside breakeven shifts from$366.01 to $367.81. That means TSLA can now rise further at expiration before we lose on the overall position (see what arrow). This provides a bit more breathing room on our bear call.
Second, the overall credit (i.e. profit potential) increases from $1.01 to $2.81 (see yellow arrow). That means if TSLA can remain somewhat rangebound we’ll make more money now that we’ve added the hedge.
Third, the trade-off for the previous two benefits is that we now have downside risk. If TSLA now falls in price below $289 then we would have been better off by not adding the bull put (see red circle).
The best case scenario after adding the Jan $290/$280 bull put is to have TSLA fall gradually back toward the middle of the range around $320 or so. In that case we would end up capturing a profit on the original bear call and the bull put spread we added. Perhaps the most frustrating outcome would be if Tesla shares took a nosedive right after we added the bull put spread. There’s nothing worse than getting duped into finally adding a bull put right before the stock finally falls in the originally forecasted direction.
Another way to illustrate the impact of adding the bull put to hedge is to view the profit zone on Tesla’s price chart. Here is TSLA at trade entry with the bear call spread.
And here is what happens when we add the short Jan $290/$280 bull put spread to convert the trade into an iron condor:
Notice how we shifted the upside breakeven higher providing a wider profit range on the upper end. The trade-off is we now have a downside breakeven so we’re going to be in trouble if TSLA falls too far.
There are myriad ways to manage the iron condor, but the ideal outcome is to have TSLA fall back toward the middle of the range allowing us to buyback both the initial bear call and the added bull put at a profit.
