Options Theory: Why Do Traders Hedge? | Tackle Trading
In part one of our new series on hedging, we defined precisely what the concept means. Today we’re turning to the why. Namely, why do trader’s hedge? After all, they could simply exit their trade to limit the loss, so why fiddle with hedging at all?
I can think of two situations where hedging a trade is advantageous. The first case involves a profitable trade and the second involves a losing one.
Compromise for More Cash
The following sentence explains the gist of why you would hedge a winning trade. Memorize it so that next time you’re in the same situation, you’ll know hedging is the answer.
I have a profitable position and am looking to reduce risk, but I don’t want to completely exit the trade.
So, I hedge. Think of it as a compromise to staying all-in or getting all-out. Let’s look at an example. Suppose I purchased a November 85 call on ABC stock for $3. Over the next two days, the stock rallies lifting the value of the call option to $4.50. Instead of exiting to lock-in the $1.50 gain, I could hedge the position to reduce my overall risk thereby making it easier to let my winner ride. Think of it this way — the hedge reduces the risk so if the stock drops back I don’t give back my profits as fast, but at the same time, if the stock continues to rise I can still rack up additional gains.
That, friends, is a win-win.
In this instance, the hedge (aka trade adjustment) I would consider is shorting an out-of-the-money call option to roll into a bull call spread. Suppose I sold the November 90 call for $1.50. Let’s look at the position before and after the hedge.
Before:
Long November 85 call with $3.00 of risk
Hedge Added:
Short November 90 call for $1.50
After:
Long November 85/90 bull call for $1.50 of risk
If the stock keeps rising, I will continue to rake in additional gains, but if it drops back I now only have $1.50 of risk instead of $3. What traders find challenging is knowing which options to use when hedging. Furthermore, how you hedge a profitable call option will be different than how you hedge a bull call spread. In a future article, we’ll walk through numerous examples to help get you started.
I Need a Band-Aid
The second and arguably more common situation where traders look to hedge is when they have a losing position. Like the winning trade scenario, here are a few sentences to memorize that encapsulates why a trader would hedge a losing position.
I have a losing position that I’m unwilling to exit. I want to give it a chance to work, but need to reduce the risk in the meantime.
The most common scenario is when you have a positive theta trade that you’re desirous to remain in so you can milk more profits from time decay. You think you can recover the loss over time, but you want to make it easier to stay the course.
That is the typical situation where hedging is more attractive than exiting. Suppose I hold a November 100/105 bear call spread in XYZ, entered initially for a 75 cent credit. Because I firmly believe XYZ will fall over time, I want to stay in the position to both milk time decay and provide the stock a chance to work finally.
In this instance, the hedge I would consider is adding an out-of-the-money bull put spread which morphs the trade into an iron condor. Maybe I add a November 95/90 bull put for 75 cents. If XYZ keeps rising the profit from the bull put should offset, at least in part, the loss incurred from the bear call.
Before:
Short November 100/105 bear call spread with $4.25 of risk
Hedge Added:
Short November 90/95 bull put for 75 cents credit.
After:
Short November 90/95/100/105 iron condor with $3.50 of risk
The final two parts of our series will spotlight when to hedge and how.
Financial freedom is a journey
The Options Theory series is brought to you by Tackle Trading.
Sign up now and gain unfettered access to all of the quality content and powerful Scouting Reports that our Pro Members enjoy for 15-days absolutely free with no strings attached and let us show you what your trading has been missing.
Legal Disclaimer
Tackle Trading LLC (“Tackle Trading”) is providing this website and any related materials, including newsletters, blog posts, videos, social media postings and any other communications (collectively, the “Materials”) on an “as-is” basis. This means that although Tackle Trading strives to make the information accurate, thorough and current, neither Tackle Trading nor the author(s) of the Materials or the moderators guarantee or warrant the Materials or accept liability for any damage, loss or expense arising from the use of the Materials, whether based in tort, contract, or otherwise. Tackle Trading is providing the Materials for educational purposes only. We are not providing legal, accounting, or financial advisory services, and this is not a solicitation or recommendation to buy or sell any stocks, options, or other financial instruments or investments. Examples that address specific assets, stocks, options or other financial instrument transactions are for illustrative purposes only and are not intended to represent specific trades or transactions that we have conducted. In fact, for the purpose of illustration, we may use examples that are different from or contrary to transactions we have conducted or positions we hold. Furthermore, this website and any information or training herein are not intended as a solicitation for any future relationship, business or otherwise, between the users and the moderators. No express or implied warranties are being made with respect to these services and products. By using the Materials, each user agrees to indemnify and hold Tackle Trading harmless from all losses, expenses and costs, including reasonable attorneys’ fees, arising out of or resulting from user’s use of the Materials. In no event shall Tackle Trading or the author(s) or moderators be liable for any direct, special, consequential or incidental damages arising out of or related to the Materials. If this limitation on damages is not enforceable in some states, the total amount of Tackle Trading’s liability to the user or others shall not exceed the amount paid by the user for such Materials.
All investing and trading in the securities market involves a high degree of risk. Any decisions to place trades in the financial markets, including trading in stocks, options or other financial instruments, is a personal decision that should only be made after conducting thorough independent research, including a personal risk and financial assessment, and prior consultation with the user’s investment, legal, tax and accounting advisers, to determine whether such trading or investment is appropriate for that user.
Originally published at https://tackletrading.com on October 29, 2017.
