I have been reading this blog for a while and decided to ask a question.
I have been out of option trading for a while and have decide to come back to it. You have been mentioning that today it's really important to hedge risk and I totally agree; that's one reason I've been out; I hadn't really figured out a comfortable way for me to do that.
One strategy I have been considering, and now
testing in my paper desk, is to sell covered calls for premium, and delta balance
the buy/write - and then hedge that buy/write with with a long ATM put 6 or 7
months out. My thoughts are that the put will protect me against big opening
gaps while costing me less theta than the premium earned by the short call.
Any thoughts?
Terry
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The overall concept is sound.
You are really talking about a collar and not a covered call - if you buy the put.
There are modifications to consider.
1) I agree that hedging is a solid idea, and it's important.
2) Overwriting, or selling more than one call per 100 shares of stock does balance the deltas, but introduces upside risk that is not normally part of a covered call strategy. I'm NOT suggesting that you avoid this play. I'm only emphasizing it to be certain you are aware.
Unless you sell very low delta calls (I don't recommend that strategy), you won't be selling many extra calls. And if you add the negative delta from buying puts, there will not be room to remain delta neutral and sell extra puts.
3) All by itself, buying puts adds a double safety feature: protected downside and (because fewer calls are sold) an upside that's not as bad.
4) The longer-term put is a big issue.
Yes, less rapid time decay is important, but it's not the whole story.
Yes, the longer term option has been shown to do better than one month puts, but data supporting that idea is limited.
Be aware that these puts are loaded with vega (that means their price is very sensitive to a change implied volatility). In my opinion, you cannot buy longer term options, ignoring how much they cost. When IV is high, you may be better off with one-month puts. When it's elevated, perhaps 3-month puts would be a good compromise. I'd own the 6-month put when IV feels 'reasonable' and the option price is not prohibitive.
There is some judgment if you adopt this idea. Obviously, if you always buy the longer-term puts, there's less judgment, and there is nothing wrong with that. It depends on your preference.
5) I want to make one more point about the puts. If you are truly buying them ONLY to protect you against large opening gaps, then near-term, OTM, not too expensive puts should be good enough. Lots of bang for the buck.
But if you want to own puts for true downside protection - gap or no gap, that's a different story and your idea is sound.
I like collars. The profit potential may not be too large, but being protected from big losses is far more important. At least to me.
Hi Mark,