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k1 Project – Covering and Hedging I – Basics and Mattress Plays

Rule #1: Never lose money – Warren Buffett

I know it’s been up, up up but down does exist – Phil

We’re exploring two related ideas in this section. The core idea is that of covering or hedging your positions as insurance against a move that goes against your plan. Add to that Phil’s Mattress Plays as a way of hedging a larger number of positions against big market moves all in one go. The idea that struck me as so powerful in my early learning stages was the idea that an understanding of hedging was what I had been missing to be able to protect and adjust my virtual portfolio to the whims of the market. Phil writes about mattress plays in comments all the time, as it is an essential part of his hedging approach, and practices ‘safe trading’ with covered plays in all but the most special of circumstances. Sage has a number of articles about covering and hedging as well, applying a broad range of options approaches. The combination of understanding, approach, and tactics are a powerful balancing aspect of the core strategy.

This entry was posted on Tuesday, November 6th, 2007 at 12:00 am and is filed under Education. You can leave a response, or trackback from your own site.

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Comments


  2. k1
    November 6th, 2007 at 12:01 am | PermalinkIgnore this user

    Quick Hits

    Not looking to make money

    The concept is easy and the real trick is finding the levels you are most comfortable with. Since I am protecting the LTP as well as the STP, I end up taking a heavy position of close puts but, if you have stock positions, you can afford to use them as more of an emergency stop.

    I must stress that I am not taking mattress plays to make money per se, but rather to protect positions but circumstances this week just made them work as channel trades that did quite well for us. Generally, I don’t even book them in the portfolio as over time I’m really just looking for these plays to be even – their purpose is to help me hold onto my longer-term positions through volatile periods.

    Protecting against a major move

    DIA plays – again and again I will say that the point is not as much to make money as to protect against a major move. These plays are not for doubles, they are to make .25 on a 150-point move and .50 on a 200 point move (25%) and are great money in a real collapse but if you don’t have the discipline to take 10% and get out, it’s very hard to win. We’re just finished a 300 point down move from yesterday’s 13,950 spike. I was lucky because I bought $140 puts during that spike and 300 points is all the move I ever wished for. Now that we don’t have a big event planneed, it’s back to December for my ordinary strangle.

    Rule of Thumb

    As a rule of thumb, once a mattress play goes bad on you and you are about to roll it, you are committing to a course of action that is unlikely to be rewarded unless you get a 200-point drop. That is what this play is designed to guard against. I cannot say often enough that this play is NOT designed to make money – it is designed to let you leave your callers on the table longer than would otherwise be prudent.

    Hmm. Was that too subtle? I’m afraid it might not be completely clear that hedging is not about making money, it’s about not losing money. :-)

  3. k1
    November 6th, 2007 at 12:02 am | PermalinkIgnore this user

    Mattress Tactics

    Entering the position
    Buy the $2 Level – because it’s easy

    Mattress play – when in doubt with the Dow, I just grab whatever is close to $2 in the current month. There’s no intense logic to this other than, because I do it consistently, I’m able to quickly glance at my plays and see how well each one’s doing and know if I should be getting out without much thinking. Also, you’ll notice that the $135s are $2.16, so it does work out quite well. Also, when in doubt, I always buy closer to the money. Right now the $134s are $1.84 – .16 the other way but that triggers my “roll for less than .35 rule” so there’s no sense in initiating a position I would roll out of.

    Roll for 35 cents

    Effectively, with 50 days to go, I’m always happy to gain $1 in position for .35. This is a logic that should apply to any longer position you believe in, if you have a 2:1 advantage in a roll (strike vs. cost) then it really doesn’t make sense to stay more than one bracket out of the money unless you are employing a specific spread strategy.

    Differentiate between insurance and downside bets

    Mattress plays. Very much depends on how much is insurance and how much is now a downside bet on the Dow. If you are insuring bullish positions (is anyone really still bullish?) then make sure you are not overinsured (when in doubt sell half, or a third or whatever applies). You could/should hedge up the other way with October calls, working into a nice strangle but, above all else – set stops to preserve at least 60% of your profit – you can always rebuy for a .05 loss if you exit too early. I usually just layer down 3 levels on momentum and remove the top (the one with the most profits) when the momentum slows or turns and I almost never have more than 2 active at the day’s end as I prefer to consolidate on the strike that is closest to (perhaps just out of) the money.

    Managing the position
    Detailed example

    I started the day 60/40 puts protecting a 90% bullish (of uncovered positions) portfolio and we gapped up, giving me a big win on the open positions and a modest win on the DIA calls and a maybe 20% loss on the DIA puts. Since I’ve got about $400K in uncovered calls and stock (not counting the DIA calls), mostly options and they gained about 20% too, the loss of 20% on my DIA puts was not a big concern.

    The purpose of the puts is to serve as catastrophe protection. If we get a 500-point drop that blows my coverage on my $1M of covered calls, dropping them about 20% in value before I can re-cover them, my $200K worth of DIA puts are likely to pick up maybe $400K, keeping me not too far out of neutral. For any other market moves, their purpose is to keep around even.

    The stop rules under mattress plays are the closest I can come to having a firm way of saying: Try to stay no more than 50 Dow points out of position and give yourself an average of no less than 30-45 days in length. We can debate the merits of those figures till the cows come home but they work for me.

    Rolling down after a big gap down

    I can’t believe it’s time but I’m going to take the DIA Nov $137 puts at $2.12 as a mattress play, rolling down my Nov $142 puts with tight stops (I also have the $141 puts, not so tight on those as they will become primary). This is not so much a bearish call as it is prudently taking a $4.35 put off the table in favor of a $2.12 put that accomplishes the same purpose but it is possible we get a bonus if it keeps going down.

    Managing a Dow strangle

    DIA strangle, by tighten I don’t mean to go the other way. If it happens by accident, fine but it’s not my goal to be in the money on both sides as that means one side is a big loser on a run. Once I’m in what I think is the range for the Dow (and I’m righ in the $137/$136 puts too) my new goal is to add 25% more to whatever side hits $2. Right now that’s the $136s. My goal is to get the basis of each side down to $2. If I have 200 puts and 200 calls at $2 and the index moves 100 points (like now it is at $137, up from $135.50 where I was just filling more $137s) then my calls (in this case) jump up 25%. This “pays” for me to add 25% more puts at $2! Then, when it drops 100 points, that “pays” for me to increase the puts by 25%.

    Managing in fast-moving markets

    If you are in strong market momentum going against one side of your mattresses, it is smart to stop out of the “wrong” side and wait to rebuy the new bracket on the turn. If you are not good at spotting tops or bottoms, one way to do this is to simply follow the mattress rules buying whatever bracket is going the other way positively to cap your losses without forcing a sale. Hopefully, at some point you get comfortable with one direction or the other and start to lighten up (nothing has to be absolute) on the “wrong” side.

    Exiting the position
    Exiting by scaling into calls (weather vaning)

    You don’t have to exit the trade by selling, you can exit the downside by scaling into calls. That way you don’t need to be such a great bottom guesser. You just start picking up $137 calls until you achieve a new strangle and ease out of all but the two close strikes on either side. Then you are back to not caring which way it goes.

    The last roll is a loser

    Mattress plays – by the way, by definition, if you keep rolling your puts or calls at each level then the last roll you make will be a loser and the second to last will be just about even! As I said yesterday, these are plays we make to scalp dimes and the big win is when I take off my $133s at $3.20 and switch to the $135s at $1.90, I’ve already taken $1.10 off the table so I’m risking 25% of my profits.

    Interesting Example Mattress Plan
    At the end of this article (Wacky Wednesday Morning) just before the comments start, Phil publishes the mattress plan for a sketchy day of trading. Interesting to see the protection plan laid out ahead of time, ready to go.

    Please read the original article but here’s a few to look at IF WE LOSE OUR S&P LEVELS. I’m posting units based on protecting at a ratio of 1/20th of a straight portfolio if you hold stocks and 40% against your unhedged calls, I’m using 25 units as an example

  4. k1
    November 6th, 2007 at 12:04 am | PermalinkIgnore this user

    Covering

    Defined

    You can sell calls against longer calls and puts against longer puts and your spread can be by strike price or date as long as its in your favor. Those are all technically “covered.”

    Covering small positions

    $10KP and $25KP – It is cost prohibitive to index put a small portfolio so I went instead with a lot of call selling (as you are guaranteed to collect the premium at worst). After last Q I decided I needed to be more aggressive with the smaller portfolios and that’s worked out so far this Q. I’ve concentrated more on a diversified mix that should (and did on Friday) keep us out of trouble on major moves while we play the middle.

    Residual value in your insurance policies

    AAPL – the Jan puts will be worth 0 the second it opens tomorrow, even if it’s negative until the stock crosses and puts them in the money. So if Apple flatlines at $95 after earnings (a possibility that wipes out all Jan option holders) then your $95 put will be worth 0 while the Feb $90 put will still fetch $2. If Apple goes down to $90, then your $95 put will be $5 but I’ll bet the Feb $90 put won’t be too far behind it. If Apple goes up to $100, the Feb $90 might still fetch a buck – obviously, not the Jan.

    When you are buying an insurance policy, it is nice if it has some residual value!

    Be aware how much equity you need to cover

    AAPL – sorry no x’s because you are not protecting your downside. I know it’s been up, up up but down does exist and you have $26.60 tied up in the long call and you are capping your gains at $2 from here (you will gain half as fast as your caller) while a $10 drop in Apple (6%) will drop your position $6.50, well below what coverage you have. The Jan $160s at $14.65 against the current $160s at $3.88 have a much better chance of success but it’s still very risky into earnings. If that’s your position I’d roll up to 2X on the $160 spread or just take 1/2 of yours off the table by rolling them up. On the whole, I like to wait as close as possible to earnings to pick a spot like that.

    Cover 40%

    Covering 40% – 40% of the value of my long contract. That’s a goal you should shoot for. It’s generally unobtainable early on but, as you reduce your basis by selling, you should be able to line that up on most of your trades. That turns it into a play you really don’t have to watch.

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