This is a simple but effective strategy that builds profits while reducing risk or, in this example, actually locking-in a minimum profit. The system can be adjusted to make fewer trades but I used these parameters to illustrate the concept. These are the actual prices of BABA beginning on 1/4/2021 as shown on ThinkBack. The strategy was to initially buy Jan2022 Calls with a 250 strike price. I used a quantity of 10 which is equivalent to 1000 shares of BABA but of course any quantity could be used to the same effect. Buying 1000 shares of BABA on 1/4 would’ve cost $227,000. The 10 Calls would’ve cost $31,775.
The strategy was to buy the 250 Calls and only make a trade if the value of the 260 Calls was equal to or greater than what I paid for the 250 Calls. In other words, the stock needed to rise in price by approximately $10/share to complete the buy 250 Calls/sell 260 Calls round-trip transaction. That completed round-trip created a $10 wide Call Vertical Debit spread that was purchased for a net Credit. After each completed round-trip I would then buy another 10 of the 250 Calls the next day. In this example I could’ve completed 5 round-trip transactions since 1/4. See the results below.
Here is the spreadsheet showing each trade cost and the accumulated net cost of the position. The trade cost varied from the initial $31,775 to as high as $49,950. The current net cost is -$11,325 or a locked-in minimum profit of $11,325.
This is what the current risk profile would look like.
The strategy can be adjusted in many ways to effect the results and the level of risk taken. For instance, as the price rose I could’ve stopped initiating a new position by buying the 250 Calls and instead bought the 270 Calls instead. Then, the Delta Hedge would’ve been selling the 280 Calls. That would’ve lowered the amount of net risk in the position by a considerable amount.
The point of this case study is to cause you to recognize the benefits of risk reduction and to understand that it’s possible to increase the leverage of an option portfolio while reducing the risk.
Questions? Comments? Let me know on the Twitter feed.
Hi Paul, thanks for outlining this interesting DH approach. For the initial Call expiring in about a year, what delta are you typically aiming for? I realize you’re using the chart to find price targets but what’s the preferred delta range for starting this kind of position. Also, how do you manage the typically high vega of the long call for cases where the price doesn’t cooperate as quickly as the one in the example?
Thanks, Anton
In this case I was showing near ATM Calls with a Delta greater than 50 however the same strategy can be used with lower Delta options to reduce the initial capital risk. I often choose the 30 Delta options in that case. The high initial Vega is not a problem since I manage the position by the chart. If price does what it ‘should’ then I’m able to eliminate the initial cost of the trade by DH’ing it. If price doesn’t move in the expected direction and triggers the stop then I exit for a relatively small loss. I do not hang onto positions if the price isn’t acting as I expected. That high Vega from being long Calls goes flat as soon as those Calls are DH’d into a Vertical Call spread.
Thanks for the reply. For this BABA trade I’m guessing by the screenshot you were mainly using the daily chart and with support on other timeframes, but daily as the main. What if you were using the weekly chart as the main trigger…would you only exit the initial position if it hits the stop or do you also exit after some elapsed time goes by where it’s not moving? And about the stop, what would be a good way to set the stop level for a trade like this?
Anton, this same strategy can be used on any timeframe, including weekly. I typically use the HB (Half-Back) line to identify the current trend and, if I’m in a bullish trade, I want to see price closing it’s current candle (in this case weekly) above the HB line. I would use the prior candle’s low as a stop at any time during the trade. If you’re not familiar with the HB line you’ll find descriptions about it in many of the posts and it’s discussed in many of my tweets. You’ll also find that I use retracements back to the Fibonacci support zone of a prior candle as good location for initiating a new bullish trade. If you’re not following me on twitter my handle is @VegaOptions. You’ll find lots of information there!