In the inventory of positions that I’m currently carrying in my portfolio I have a bearish trade in MSFT and a bullish trade in AAPL. That doesn’t make much sense does it? If AAPL goes up then MSFT will likely move in the same direction and vice versa. That’s probably true. On the other hand, combining the two directionally opposite positions means that if those two stocks move up or down I’ll likely have a fairly large profit. I’m covered in both directions. Let’s take a look at the two individual positions and then the combined position.
The risk profile below is the MSFT position. I’ve locked in a minimum $1,900 profit and the position has a maximum profit of $11,900 if the price of MSFT is at 200 by Jan15 expiry.
The risk profile below is the AAPL position. I’ve locked in a minimum $170 profit and the position has a maximum profit of $10,170 if the price of AAPL is at 130 by Jan15 expiry.
Below is the risk profile of the combined position Beta weighted to MSFT. A price move of around plus/minus 7% should yield the maximum profit of around $12,000. My biggest risk is if price moves less then 3-4% by Jan15 expiry. If that occurs then I will give back $2,404 of my current $4,474 open profit. So, even though I can do no worse than make a $2,070 profit on this combined position, that doesn’t mean it’s a risk free position. The risk is always defined as the current open profit minus the minimum guaranteed profit.
That’s the bigger picture of using a Delta Hedging strategy as opposed to just taking profits and closing positions along the way. I’m now indifferent to whether these stocks go up or down. I’ll make money in either direction. Sort of like a synthetic Straddle. My job over the next week or two is to try to find another entry in either stock to fill out the center portion of the risk profile so that I can make a nice profit no matter what price those two stocks are at on Jan15 expiry.
Questions or comments? Let me know on the twitter feed.