Advanced Option Trade Management: In the Final Part of Our Series on Option Trade Management, We Will Cover Additional Methods for Hedging Position Risk, Including Using the Underlying Contract and We Will Discuss Simple Techniques to Measure Volatility
Steelman, Robert, Mayela, Sandrina, Modern Trader
In the previous two parts of this series on managing position risk in options, we have presented some fairly simple, but effective, techniques for hedging. These included simply exiting the position, buying protection using a spread trade and increasing exposure by selling expensive near-the-money options.
While these techniques provide a formidable portfolio of tools for hedging, there are even more ways you can protect your profits or trim your losses. One approach is an extension of the basic spread positions. Known as straddles and strangles, these flexible positions can profit in interesting ways.
BUILDING A BRACKET
One choice you have for hedging an option trade going wrong is to take a position on the other side of the market by creating a bracket at the point where your position would be either profitable or break even. You do this by selling the opposite type of option that you had originally sold. For example, if you were originally short a put, then you would sell a call.
This is called either a short straddle or a short strangle. With a straddle, the strikes are the same. With a strangle, the strikes are different. Both positions achieve their highest profit when both the call and put expire worthless. Needless to say, this is also a fairly risky action to take because, theoretically, you would be facing nearly unlimited losses on either side of the market.
The key to a straddle or strangle is to know when it would be applicable. The proper time for this strategy is when the market is trending and does not show any signs of correction but rather looks to consolidate.
Analyzing the reasons behind the move can provide some clues. Moves fueled by clear fundamental changes in demand or supply generally do not correct via opposite price moves but instead level at certain points. For example, if the demand for a certain commodity is expected to increase without an adequate increase in supply, then most likely the price will eventually consolidate rather than plunge back toward lower levels.
A market that provided a somewhat easy-to-predict opportunity for a bracket trade was the corn rally during the fall of 2006. There was a genuine concern for supply in the face of higher corn-based ethanol production.
Another instigator for an upward trend is the risk premium of a certain commodity. For example, the entire energy sector has had a substantial risk premium embedded in the market price since the hurricanes in the summer of 2005, and due to the political tensions in the Persian Gulf region because of supply concerns.
As the hurricane season of 2006 passed without incident and the war with Iraq and other political tensions in the Middle East didn't produce significant supply interruptions, the risk premium bled out of the market and the price of crude oil declined substantially.
The critical question when placing a straddle or strangle is the strike of the new option. You need to decide how much premium to bring in for the risk assumed.
The art of this trade is balancing the width of the bracket with the premium intake; you want to create a bracket wide enough for the time until expiration and at the same time bring in enough premium to cover the potential swings.
No matter how you structure this trade, however, this position is usually a nail biter regardless of the direction the price moves. The following are important points to keep in mind:
* The more time that is left until expiration, the wider the bracket should be. Analyze how much the market moves, on average, within the length of the period left until expiration for the original option. The average true range indicator, or a similar measure of volatility can be helpful here.
* Your account size. Nothing is possible without the funds to do it. Your account needs to be funded accordingly so that the new position will not likely invoke a margin call. …