Last update: July 2021

Hedging is a concept all veteran trades know very well. The concept is fairly straightforward, the investor has a trade or trades that he or she would like to protect. By making the second trade to protect the first trade or trades is what a hedge is. For example, buying a put option to insure against the risk of earnings is called a protective or married put, this is also called a hedge. The trader buys a put option to protect the investment in the stock. Another one is buying put options to protect a retirement account, this is called a portfolio hedge.

The one I wish to discuss briefly is a hedge on economic reports for Theta traders.

Theta trading is very popular amongst active traders as we benefit from the one thing we can promise and that is time will pass. Regardless of the direction, we know time moves on so we design portfolios to benefit from the passage of time. When you are primarily a theta trader the risk is to direction and increases in volatility. As we have seen in the month of January, there is an increase in both of these to theta traders. This does not mean we do not make these trades. We need to learn to protect theta portfolios.

The risk on a theta portfolio is Gamma which measures the speed of direction or delta. With major economic reports, we can expect increases in gamma and Vega which if it goes in the wrong direction can really mess up your theta trades.

A typical hedge is for the trader to identify the negative gamma in the portfolio and buy enough straddles on the SPY or other market index ETF to offset the gamma risk. Bringing it up to zero for the economic event will suffice. What this does is insure your theta trades. If the market moves dramatically on the economic report, you will lose money on the theta trades. However, you will offset that with the increase to the Straddles which are Vega trades.

This is a trade that takes practice but if you are a core theta trader, it is one you need to learn to offset your risk to economic events like the ECB last week and FED this week.

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