-Balancing (Part 1)
Many of us start learning to trade – and specifically, learning to trade options – by taking a course or reading a book. And most of the courses and books say, “It’s easy and you’ll make tons of money.” Of course that’s true – but only after you have internalized that information as well as learned and understood the psychology of trading. (That’s something I’ve only really begun to study, myself. I’m now convinced that with the right mindset, you don’t need indicators or anything but price and volume to trade, and that the most important knowledge – how to think like a trader to take money from those you’re trading against – is largely ignored by the majority of books and courses out there.) Of paramount importance is that it’s more important not to take a trade than to take one (especially if you have any doubts or haven’t really evaluated what could happen to the position), and to – as one of my trading mentors says – “above all, do no harm.”
Instead, we all tend to rush into placing trades (I’m an expert in making this mistake: been there, done that, and got the T-Shirt), and even after we get really good at learning the language of the market, we don’t always keep our positions properly balanced or hedged. Consequently, you might have a bias that says, “I expect the market to go up this week or next month” and put on a lot of positions to take advantage of that move; but how do you protect yourself if, instead, the market goes down. Or suppose you have some individual positions for December – such as a bullish spread on AAPL or a bearish spread on APOL – and the market moves against those positions? Maybe you’ve done your homework and think that AAPL will move higher or that APOL will move lower, but in the meantime the market moves down (sucking AAPL down with it) or up (pushing APOL back the other way), and, until next month at least, you’re stuck with red in your account?
You may be confident in your bias and in the positions you have on, but you may also find yourself hurting if market-timing – or some earth-shaking intervention by the Fed – gets in your way.
What to do?
What is Hedging?
That’s where hedging comes in. Hedging is any means of offsetting your exposure and reducing your risk. The objective of hedging is to let you benefit – as much as possible – from any move of the underlying stock or index in your favor, while minimizing – as much as possible – the impact of any move against your position.
Hedging can be accomplished easily, even when you put on positions:
- When buying individual options, avoid front-month options and make sure they have more than 30 (and preferably more than 60) days to expiration to avoid the theta burn of front-month options.
- Instead of buying individual options, instead buy or sell spreads (the combination of a purchase of a put or call at the same time you sell a put or call) to minimize theta burn (or to leverage it) and minimize delta loss if a position goes against you.
- Buying SPY or QQQQ calls against a set of largely short (or delta-negative) positions, or buying the corresponding puts if you’re largely long (or delta-positive). We’ll talk about this specifically, below.
- Buying DX (dollar futures) if you’re largely long stock (since lately it appears that if the market falters, the dollar will benefit, and vice-versa), or selling DX if you’re largely short stock.
- Buying TWM shares or calls (or selling TWM puts) if you’re long RUT or IWM calls or shares.
- Limiting your risk by limiting the number of contracts used to take on a position: if you like the position but have some concerns, limit yourself to a smaller number of contracts (maybe as little as ¼) that you might normally use to put a position on.
We all want to profit by market moves, and we all get excited about using options to leverage those moves. But – and this is especially true for those of us who are new to options, like myself – we don’t usually take into account what can go wrong, and what we can do to minimize the negative impact of an adverse market move.
In short, hedging is how you evaluate your aggregate risk and decide: how exposed are your positions and what kinds of insurance coverage will it take to protect you from an adverse market move? Like all insurance, no one wants to pay the premium, no one wants to have to use it – and everyone is really glad they have it when it’s needed. What we’ll discuss here is how to determine how much coverage you need and how to acquire it – and not spend too much money (or time) getting it.
Consequently, the objective of hedging is to step back from individual positions, look at them in the aggregate, and decide: what will hurt my portfolio the most? (Hey, even if you only have 1 position on, it’s a portfolio!) What can I do to offset – with as little cost as possible – the possibility of the market moving against these positions?
Hedging and Delta
If we’re going to measure the impact of an adverse move on the aggregate of our positions (our portfolio), what measurement do we use? That’s where delta comes in.
Options aficionados all know what delta is, but for the newbies: delta the “greek” measurement that tells us how much an option price will change relative to a change in price in the underlying stock or index. In other words, if you had bought a Dec 110 SPY Call before the close on Friday (11/13), the delta was .48 (the Call itself sold for 2.58, and SPY closed at 109.62). That means that if SPY opens up by a dollar on Monday at 110.62, the Call should price at approximately $0.48 more or $3.06 (for simplicity in this example, we’ll assume no other impact from changes to volatility, etc. – I’ll leave that for one of our more advanced contributors to discuss in more detail). Conversely, if SPY opened down a dollar ($108.62), the Call should price at $0.48 less or $2.10.
Calls always have positive delta (because they represent the right to purchase the underlying, it’s really the same, delta-wise, as owning 100 shares of the underlying for each contract). Conversely, puts always have negative delta (again, they represent the right to sell 100 shares). But options aren’t the only instrument with delta: stocks and ETFs have delta as well. The difference? A share in a stock or ETF always has a delta of 1 (since a movement up or down in the price of the stock or ETF has a 1-to-1 correspondence with the price of a single share). So if you buy 100 shares of SPY, that position will have 100 delta (which is sometimes stated “long 100 delta” or that you have “positive 100 delta”); if you short 100 shares of SPY, you have -100 delta (or you’re “short 100 delta” or you have “negative 100 delta”).
You can easily determine the delta of an option (along with other greeks) if you’re using a contemporary options-trading platform. For example, in ThinkOrSwim (TOS), the options chain will display these:
Notes I’m using SPY to beta-weight. If you prefer, use something else as I suggested above To learn how the current set of positions will do if we move up or down 2 SPY points from here, I’ve modified the Price Slices to be 111.50 and 107.50. You can instead use percentages or some other measure The key is in the Price Slices window:
You can see that currently, the overall portfolio delta is 203, and currently the Profit/Loss is -$1105 (obviously, a few positions are in the red pending expected market moves this You can see that currently, the overall portfolio delta is 203, and currently the Profit/Loss is -$1105 (obviously, a few positions are in the red pending expected market moves this coming week and into December). If – and only if – none of the underlying positions change (which won’t happen, of course) and SPY goes to 111.50, the overall Delta will go to 238.79 and the P/L will be -$668; if it drops to 107.50, the Delta will go to 151 and the P/L will go to -$1482.
What can we learn from this?
- The portfolio is largely bullish (delta positive) and will benefit from a market move up.
- Not only will the value of the portfolio go up as SPY goes up, but so will the Deltas – so the portfolio positive value will increasingly improve in response to moves up in SPY.
- And, if SPY goes down, the portfolio will pick up more negative deltas and get more in-the-red, increasingly so.
Now, like a lot of folks on HOB, I’m expecting an up-move for the week of Monday (11/16) or at least a consolidation period: it’s Opex week, which are generally bullish (and boy have they been bullish the last several months). But eventually (bulls note this point) every trend will end: no market goes to a million or to zero. After this coming week, we could see an intermediate move down of significance (perhaps even before the week is out). We know the overall delta of this portfolio, but how do we make it more delta-neutral to adjust (especially if we get our move up to 1108 and then start a move down) for a retrace that will eventually, inevitably happen?
Hedging Your Portfolio By Balancing Your Deltas
Hedging Your Portfolio By Balancing Your Deltas
Hedging Your Portfolio By Balancing Your Deltas
The key is to adjust your overall portfolio delta by creating positions that represent more positive or negative delta, as needed. In the example portfolio, we’re net 200 deltas. Once I’m ready to give up my temporary bullish bias (as a good trader, always be willing to adjust your bias on a regular basis), I’ll want to add -200 delta – perhaps more. So we can buy SPY Puts (or sell SPY Call spreads) to adjust the deltas.
For example, suppose I want to add approximately 200 negative deltas right now. An easy solution would be to buy Dec 109 SPY Puts (each is -46 Delta) for $2.84/contract (or $284/each). In other words, I can buy 5 Dec 109 SPY Puts for a total of $1420 to acquire the negative Deltas I need. (Note: you don’t only have to use SPY puts, and they don’t only have to be for December – I’ll show a number of alternative examples below.)
You can simulate this in TOS by navigating to the Add Simulated Trades menu, right-click on Dec 109 Puts and select Buy | Single, then adjust to the number of contracts you want. The number of deltas for the entire set of contracts is shown on the right of each position in the Positions and Simulated Trades area, and when you switch back to the Risk Profile view, the new simulated position will be included, along with the additional negative deltas:
Note: I’ve added a number of simulated positions here, which I’ll use in later examples, but only the 5 Dec 109 Puts are being added for this screen shot (see the check box?).
Notice what this does to our portfolio:
- Overall Deltas are now -27 – we’re in a net negative delta position and much better positioned for a down-move
- We didn’t have to adjust any of our other existing positions.
- Our current profit position has only changed by about $5, so for the present, the change doesn’t affect our overall profit.
- We’ll have fewer Deltas going up (about 55), but we’ll have lots more negative delta going down.
- We’ve decreased our profit on a move to 111.50 (which is why we’d want to wait until the market confirms the down-move and only do this then and not right now), but we’ve reduced our loss if SPY moves to 107.50.
So we’ve accomplished an initial hedging and balancing of this portfolio. That’s the good news.
The bad news: it’s going to cost us $1420 (not including commissions) to buy these puts. Are there better approaches? Can we get more deltas per dollar?
Further, you may have noticed another difference between the hedged and unhedged portfolio: our theta loss – the rate at which our positions are deteriorating due to time value – increases from $56/day to $79/day which further eats into our profits. Now, part of this is due to the fact that we have a number of debit spreads in the portfolio (with more credit spreads, we’ll have more positive theta). Is there a way we can hedge but offset some of our theta loss?
And, note that the portfolio margin was originally zero – but after this delta adjustment buying Puts, we’re now carrying $1420 in margin, and that reduces our overall buying power. Are there ways that we can hedge without tying up as much margin?
The answer to these questions: yes, and that’s what I’ll discuss in Part 2, in the form of several different alternatives for addressing these issues.
Richard Hale Shaw
