Hedging Tactics For Options Traders

July 31st, 2023

Hedging Tactics For Options Traders

The S&P 500 reversed direction on Thursday, following stronger than expected economic data.

With the recent run-up, a pullback in price action was needed and it’s also instructive for our recent series on protecting yourself against sell-offs or corrections.

Today, I’ll show you how we constructed our Inverted Ladder and alternatives you can use to that trade tactic.

The “Slinky” concept

Just like the child’s toy that can walk itself down a flight of stairs or an inclined plane, I would look for a ‘level-by-level’ move lower in a correction. 

In the graphic below, in the lower right hand frame, is what I would expect to see if or when the S&P 500 corrects.

By using key support lines, I’d expect to see each line tested – and either holding as a new support line or breaking and giving way to the next line lower.

SPY Daily Chart

As an alternative to the Inverted Ladder (vertical put spreads) we shared with you on Friday (and a day late and a dollar short we were with Thursday’s wide sell-side action), you can use these support levels to buy individual puts.

Here’s a sample – this data pulled at 8am Friday, so please, reprice.

18AUG23 440 PUT – this is the next leg down and is currently the highest volume/open interest put for the August monthly expiration.

The price, at the time of this writing, is $1.60, or $160 per contract to buy the 440 Put on the SPY.

I’ll assume a $50,000 trading account and a hedging allocation of ~2.5%, or $1,250.

As there are multiple levels to the downside, I’d want to allocate a position of 25% of capital ($1,250) to any hedge I’d play. This prevents gambling on a move lower, especially with a market that keeps driving higher.

That means I can buy 2 Puts, or $320 in capital at the 440 level and have capital available to buy additional levels lower: 435, 430, etc., if the SPY moves in my favor.

A 5-point move to 445 on the SPY has the potential to double the value of that Put (it could be higher, too, but we’ll be conservative here) and I would have just over 3 weeks for that move to happen.

Which could yield a $320 gain, or better at 2 contracts traded. Now, let’s be honest, that’s not a huge gain in dollars.

But, when you’re hedging the stock market, you’re not going to go fully bearish with your entire portfolio – you’re looking to offset capital losses or valuation losses in the short-term until the market corrects itself and resumes moving higher.

If the market does move in your favor, you can then add exposure at lower strikes with the same capital allocation approach (approximately $300 per position), but not going above the 2.5% total allocation to hedge your portfolio against a correction.

I’d also want to limit my exposure because if the market does not move in my favor, then I’d want capital on hand in the future that I could use to hedge when markets weaken.

In the short term, I’d hedge with the 440 put and wait until the market moves below 445 or even until it tests 440; then, I’d look to add the 435/430 puts.

Key factor to consider:

Time: is always issue or problem #1, right? The timing of a long option against the premium decay.

When hedging the index, I don’t want to look further out than 45 days because many sell-offs or short corrections happen within 5-15 days.

In the chart above, the mid-June sell-off took just 7 days to complete. That’s not a lot of time to collect your gains. With an impatient market – a market that wants to move higher – it’s important to me to be willing to take smaller profits off the table in less time to ensure a winning trade.

So even in our single-sided put buying approach, I’d look to do the following at a minimum:

Close 1 contract when return on capital is greater than 50%. If the value of the put rises to $2.40, I’d take that 50% off the table and hold the second contract up to $3.20, or 100%.

If you get lucky and the premium rises more rapidly – you wake up one morning and the value has exploded higher than 100%, don’t get greedy (please). Take the win and the money and don’t beat yourself up if you don’t get the ‘top dollar.’

This is also the approach I would take with the inverted ladder: closing one rung at a time when profitable, especially the closer in expirations.

For the moment, this will wrap up an overview on ways to hedge the S&P 500 against a correction. Tomorrow, we’re going to the other side – the call side and how you can use calls to hedge the S&P 500.

See you in the morning.

 

John Hutchinson
Traders Reserve

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