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Options Theory: When to Place Your Hedge

November 5, 2017

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Options Theory: When to Place Your Hedge

This is the third part of our ongoing hedging series. You can find part one and two here and here.


With a sound foundation on the what and why of hedging, we’re now ready to dissect the devil. You know, the one that’s in the details. The anatomy we’re after today is that of timing. Namely, when do I place my hedge? You’ll recall we outlined two situations where hedging a trade is advantageous. Let’s start with the winning trade.

I have a profitable position and am looking to reduce risk, but I don’t want to exit the trade completely.

If my profitable position were a bullish one, I would add the hedge once the stock started to weaken. At a minimum, I need a break of intraday support. Otherwise, I’d look for a break of the prior day’s low. Remember, I’m not concerned if the stock keeps rising. That will deliver additional gains to my bullish position. It’s a weakening that I’m worried about, and evidence of that comes in the form of a price breakdown.

Imagine I bought a Dec $160 call when AAPL broke out three bars ago. The king of all i-Things has since ripped higher to $169.04. I’m sitting on a hefty profit and like the quote outlines above “am looking to reduce risk, but don’t want to exit the trade completely.” So, I’m considering selling the Dec $170 call as a hedge. It will morph the long call into a bull call spread.

In timing the entry of the hedge, suppose I wait for a break of the prior day’s low which is $166.94 in this example. After all, if AAPL keeps rising there’s no sense in reducing the exposure of my long call, right? And if AAPL established another up day tomorrow, then I could use that day’s low as my new line in the sand for entering the hedge. At some point, the rally will peter out, and we’ll see a down day. That is when I’ll open the hedge.

Now, what if the prior day’s low is too far away? Or, what if you want to hedge your bullish position at the first sign of weakness? In that situation using an intraday support level might make more sense. In AAPL’s case, it closed at $169.04 and the prior day’s low was $2.10 away at $166.94. If that’s too far away to use as a trigger then, again, look at intraday support. Here’s the 5-minute chart:

You can use the same principle when hedging profitable bearish positions (like a long put or bear put spread). Except, in that situation, you’ll be using a prior day’s high or intraday resistance as your trigger for adding the hedge.

Now, what of the second more common situation where hedging is advantageous?

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.

Imagine I deployed a bull put spread during the pullback shown in General Motors below. Maybe I entered on the second last candle when the stock started to recover from the down gap. If the small bounce that has materialized so far reverses, when would I enter a hedge? The answer is if/when GM breaks the daily support pivot. In this case, it’s unnecessary to use an intraday chart because we don’t want to add the bearish trade prematurely.

By using a daily pivot, you require the trend to change before adding a hedge. That prevents you from getting tricked into a hedge that you don’t end up needed. Now, GM can still reverse higher after breaking support, but it’s less likely than doing so after a random down day.

Here’s another way to think about it:

If GM remains above support, then I like the odds of it moving sideways to higher. I want to stay in my bull put. But, if that rascal breaks support then the odds of it running sideways to higher aren’t as good. Consequently, I’ll add a hedge (probably a bear call) to reduce my overall exposure. That way, if GM really bites the dust, I’ll lose less money overall. And, if it does end up recovering I could still win in my position.

The same principle applies with losing bearish trades, only with resistance pivots.

Summary

Tackling the question of timing comes down to identifying when the stock you’re trading has changed enough to justify morphing your trade. Much of what happens on a day to day basis is noise. It’s the noteworthy days, those that break support/resistance pivots, that typically warrant the adjustments.

Let me end with a pro tip. If you really want to see if being proactive and hedging your trades is helping, then journal them. I use the Tackle Trading Journal religiously, and I identify which trades are my normal ones and which are hedges. That way at the end of the month, quarter, and year, I can calculate whether I made or lost money overall on my hedges.


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