Ali asked a great question in the clubhouse that I want to respond to for today’s post. It’s a situation every single option seller has been in so I suspect many will find the answer enlightening. I’ve modified the wording slightly to simplify.
I need some ideas on how to effectively hedge and protect the following Bull Put Spread: BABA November $165/$160 Bull Put. Entered Oct 9th on a bull breakout pattern with a plan to exit before earnings on Nov 2nd. However, the stock is now pulling back and I would like to know the best strategy to hedge and protect the position during earnings if I wish to keep it going as I have a lot of hope for BABA.
Let’s start with what I like about the trade. First, the timing of the entry was proper. On the 9th, BABA was breaking above a horizontal resistance level justifying the entry of a bullish trade. Second, at $165 the short strike price was below support and the 50-day moving average giving a wide margin of error. Third, with earnings looming almost one month in the future, there was arguably enough time to be in and out of the trade by then.
As a reminder, when you enter short volatility strategies (like a bull put) in the weeks leading up to earnings, you can’t rely on time decay to chip in as much as usual. The rise in implied volatility that almost always prefaces earnings will keep option premiums juiced.
To capture enough profit before earnings, then, we really need BABA to continue rising after the breakout. Here’s what it’s done since:
Despite an initial push higher, BABA eventually fell back. And now it’s on the verge of breaking a support pivot today. On to Ali’s question – “what’s the best strategy to hedge and protect the position during earnings if I wish to keep it going…”
Here’s my first concern. It looks like the original plan was to exit before earnings, but now Ali is considering holding through the announcement. The hope, obviously, was to make the bulk of the profits somewhat quickly, so he didn’t have to ride through earnings. But now that BABA is going against him, Ali is thinking – hey, maybe I should just ride through the event. This is similar to someone who buys a stock for a trade but turns it into an investment because it went against them and they didn’t want to take the loss.
The only reason this is acceptable is if the position was sized appropriately. It has to be small enough so that if BABA gaps considerably lower, then Ali can stomach the max loss. Otherwise, it’s unacceptable to ride into earnings. For example, let’s say he got 60 cents credit when he initially entered the spread which means the max loss is $4.40. If based on his risk rules he can lose upwards of $400 or so per trade and he did one spread only, then sure, let it ride into earnings. But, if he did three spreads with some $1,320 of total max loss, then holding into earnings carries way too much risk.
Now, what of adjusting the trade to reduce the risk of holding into earnings? Well, to minimize the exposure on a bullish position you have to add a bearish trade of some sort. And if we’re sticking with the objective of creating a high probability, positive theta position, then that usually means we add a bear call spread which turns the trade into an iron condor. Here are two considerations.
Add a Nov $190/$195 bear call for 75 cents. This morphs the trade into a $160/$165/$190/$195 Iron Condor for a net credit of $1.35 (assuming Ali did, in fact, receive 60 cents for the bull put). The max loss drops from $4.40 to $3.65.
Add a Nov $185/$190 bear call for $1.09. This morphs the trade into a $160/$165/$190/$195 Iron Condor for a net credit of $1.69. The max loss drops from $4.40 to $3.31.
If BABA ends up rising mildly, remaining stagnant, or falling on earnings, Ali will be better off with this adjustment than just holding the bull put into earnings. The drawback, however, is if BABA rips higher on earnings, Ali will take a loss on the bear call.
Personally, I’m not a big fan of riding a losing bull put into earnings unless that was the original game plan. Relying on these quarterly events to bail you out is kind of a crapshoot.
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