Tag Archives | owning short-dated options

Less Costly Method: Hedging with put options

I’ve joined the impressive group of writers who publish their thoughts at the new CBOE blog

The following excerpts comes from a recent post by the (Surly Trader)

Put Spreads as an Attractive Hedge

Hedging equity positions [with puts] can be fairly expensive, but there are very attractive ways to mitigate that cost.

Bearish Diagonal Put Spread

I like the (bearish/reverse?) diagonal put spread strategy for a number of reasons: [MDW: I would call it ‘reverse’]

I am purchasing implied volatility at much lower levels by buying the short dated put, making the short dated downside protection fairly inexpensive.

I am selling implied volatility that not only takes advantage of the steep skew, but also takes advantage of the fact that longer dated options are trading at higher implied volatilities than short dated options.

I hope this brings some new ideas to your option trading strategies.

My all-time favorite hedge is one step removed from here – a bearish ratio diagonal put spread in which I buy short dated put options and sell a larger number of far out of the money longer dated put options….

He (ST) is advocating buying a front-month, less expensive, put option and selling extra longer-term, farther OTM puts. Two points:

  • Less expensive because it is front month an d has much less time value (obviously), but also
  • Less expensive because it has a higher strike price and thus a lower (becasue of skew) implied volatility

    I like part of this plan, but prefer not to sell naked options.

      Example, Surly Trader’s play may be:

        XYX is trading ~520 to 540

        Buy 10 XYZ Jun 500 P
        Sell 30 XYX Nov 420 P

    I’ve previously written about a similar plan. It’s the coward’s version. He sells naked options and I sell option spreads. But we both suggest owning the short-dated options. I encouraged that idea as a risk management method for adjusting iron condor positions in The Rookie’s Guide to Options.

    In the coward’s version, I sell 30 or 40 put spreads (vs.10 puts bought): It’s not easy to know which strikes because so much depends on IV. Yet a reasonable guess is the 420/430 P spread or the 430/440s.

    If the market makes a steep decline, My long put will prove to be very profitable – perhaps explosively so due to a much larger IV increase (as measured by IV points, not in $) in the front month options . This represents a situation in which positive gamma becomes our ally – and there is no worry about fighting negative gamma.

    The shorts are spreads, with limited losses. Profitability for the whole trade depends more on how far the market moves and how much time remains in our long options (time value can be significant, even during the last few days prior to expiration) than on the price of the short spreads.

    This reverse ratio diagonal spread produces favorable results when:

    • Rally occurs with volatility decline. Longs expire, Cover shorts cheaply
    • Large, rapid decline
    • Time passes, longs expire, but shorts decline by enough to turn the whole position profitable. This is the result of owning cheap Jun options (and not costly Nov options) as protection against the Nov shorts

    This trade is uncomfortable for many traders because they know must buy new protection, or exit the trade.

    Despite the apparent ‘backwardness’ of this trade, at times it can be the best choice – if not as a stand alone trade, then as an adjustment for a credit spread gone awry. I would not make this my strategy of choice. But it has enough going for it that it is always a consideration. And it is ST’s favorite.

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