I want to preface this lesson with an explanation of why this trade will look larger in size than my typical trades from the past in this service. I used to have 2 separate trading accounts that go back many years and I finally got tired of the occasional mistake of hedging a position in one account for a trade that was actually open in the other account. It could still be managed that way but it was a pain in the ass so I’ve consolidated the two accounts as of the first of this year. Always know that I observe strict risk management practices and I never ‘go all in’ on some trades. Most of my SPX trades are standard size and I often do smaller size on other instruments. I frequently place trades in order to demonstrate a strategy for this service because real trades are better than simulated ones for teaching purposes. Because of the many advantages of trading SPX that is my primary trading vehicle.
Here’s my current SPX position. I’ll break down the components next in this post but for now let’s focus on the big picture. I titled this post “asymmetrical reward/risk” for the very reason that this position is structured the way it is. One of the advantages of trading options as compared to buying stock is the ability to have potentially very large reward/risk ratios. In this position that ratio is close to 10:1 but that can change through this expiry week. Any SPX position that contains horizontal spreads (time spreads such as Calendar’s and Diagonals) is dependent on the VIX price level at expiry whereas vertical spreads are not. Below is the current risk profile of my position with the VIX at 33.09 at Friday’s close. I went into the weekend wanting to minimize directional (Delta) risk so that number is around 20. The Theta is a positive 2,000 but, if the VIX holds the 33 level and price is virtually unchanged for the week by Friday I’ll earn an average of about $4,000/day in Theta. Let’s breakdown the components now because that is key in understanding how to hedge a position like this.
When hedging a position I have to take into account all of the Greeks, not just Delta and Gamma. As I mentioned, any position that contains time spreads is highly dependent on the level of implied volatility (IV). When referring to SPX specifically then the VIX accurately represents the IV. If SPX price continues lower it’s likely that the VIX will at least remain above the current 33 level and could potentially increase. That’s good for the position as the Vega is +1,900. An increase in the VIX ‘inflates’ the profit tent and pushes the potential profits higher. Below is the breakdown of the exact components of the position. Numbers 1 – 3 are time spreads. Number 4 is a Broken Wing Butterfly (BWB). That is my upside hedge. Why that option structure as opposed to a bullish Call Calendar or Diagonal? It all has to do with Vega.
Any version of a Butterfly is the most perfect option structure (for index trades such as SPX) as far as Vega is concerned. If SPX price declines then the Butterfly’s Vega increases which matches the fact that as SPX declines the VIX typically (but not always) increases. That reduces the loss of the bullish BWB. If SPX price increases then the VIX typically (but not always) falls as the Butterfly’s Vega is decreasing. That tends to increase the profit that the Butterfly is generating. That’s what makes a Butterfly type of structure a satisfactory hedge for a position that contains time spreads. One other thing to note; I’ve given the BWB 18 days to expiry (DTE) whereas the short options in the time spread expire Friday. That makes for a much more effective upside hedge.
Once trading begins on Monday and the weekend risk has passed I’ll likely make changes to this position depending on the price action. In other words, I can add more time spreads or reduce the size of the BWB hedge if I think price is heading lower or I can reduce the time spreads or increase the size of the BWB if I think price is heading higher. One way to reduce the risk of the time spreads is to Delta Hedge them by rolling down the long strikes to turn the Diagonals into either smaller Diagonal spreads or even Calendars.
Now this all may seem a bit complicated and it is but what I can tell you is that in order to be able to elevate your game to the highest level you’ll need to be able to establish and manage positions like this. I’d be willing to bet that 90%+ of all option traders will never own a single position like this in their entire life and yet professional traders would recognize a structure like this immediately. I’ve been able to stay in the game all of these years by finding ways to increase the reward/risk ratio while managing all of the Greeks, not just Delta.
Don’t worry if you don’t fully understand this position yet! Keep focusing on using the Delta Hedging strategy to reduce/eliminate risk on your current positions. That step alone elevates your game above the majority of option traders. That gives you an edge! Since I’ve mentioned that I think I’ll give you a bonus section for this post. Below is my current TLT position. It should serve to reinforce the Delta Hedge strategy and explain how I deal with a price reversal on a chart while I’m holding a Delta Hedged position.
Below was my initial position In TLT. I saw a bullish setup on the daily chart, bought Calls and then DH’d the position by turning it into a Condor as TLT moved higher. Pretty standard stuff for you all now. Below is the zero cost tweet as well as the position.
I was fine just holding that bullish zero cost position until the daily chart indicated a bearish setup. Time to close the bullish position? Hell no! I had no idea idea if that bearish setup would follow through or not. Here’s the tweet about the setup.
So if I wasn’t going to close the bullish position what do I do? Establish a new bearish position is the answer of course. I simply bought some Puts. I went bigger on the Put side then my initial Call purchase. Below is the current risk profile as of Friday’s close.
I’ll agree, not a great looking position! But, as always, let’s consider what it could look like with the application of a Delta Hedge. Below is the risk profile I could’ve had as of Friday’s close.
There is no possibility of a loss and I have still have some nice upside potential if TLT reverses higher again. This type of position acknowledges the fact that ‘predicting’ future price action based on current price action is difficult at best. Price can, and often does reverse and it’s critical to trading success to be able to capture relatively small price moves in order to eliminate initial cost while still maintaining the potential for larger profits. Without that potential you’re nothing more than a scalper and scalpers rarely survive the market!
Questions? Comments? Let me know on the twitter feed.