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k1 Project – Covering and Hedging II – Complications

"Hedging is, in part, an admission that you may not know everything – that you may in fact, be wrong about a few things and are willing to pay to insure against that possibility." – Phil

"Don’t forget to place a value on flexibility. A lot of times, I buy out my caller just so I have a clean slate. I may resell it later but having to execute a sell, then a buy on a big market move slows you down." – Phil, on Flexibility

(In the previous comment, I think Phil means it slows you down to buy back a call on a big market move. Sometimes he’s already on to the next thought while his fingers are still spooling out the typing buffer)

This section covers a number of issues that come up regularly regarding covering and hedging, but for a variety of reasons are more complicated than the basic covering and mattressing tactics. As you read, please keep in mind that just because it’s more complicated than the other tactics does not make it more successful or profitable.


Phil about learning why to hedge

Once I lost $45,000 while flying from NY to Houston on a market dip but worse than the fact that I had arrogantly not hedged my positions was the foolish way I overreacted and tried to "win it back" once I got to Houston, far away from my regular trading desk and most of my notes. I quickly doubled my losses and had a very gut wrenching plane flight home, with my virtual portfolio in turmoil – left to the whims of the market. I often tell members that I don’t mind losing money as long as I learn something but that’s total BS when it costs you $90,000 to find out your positions aren’t as strong as you thought they were. The lesson I did learn from that trip was not how to hedge, that cost me many, many thousands more, but at least I learned that I SHOULD hedge – and now I do it well enough to teach it to others.

Reading List

Hedging Your Way to Fun and Profit – Once Upon a Mattress Play

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  1. 2:1 Recoveries
    Often flying through comments purely as a “2x” roll, this is a somewhat complicated tactic to understand, but deeply useful for those occasions when a stock pops on you and leaves you with both long and short positions in the money. The key to understanding this strategy is to follow the premium on all of the options involved: your initial long call, your initial short call, and the positions you are trying to roll to. There’s no easy way to grok this strategy, you need to focus on the starting and ending positions and their premiums.

    The problem: I bought the SHLD ‘09 $140s for $30 (as you suggested), but I picked up my OCT $125 (yikes!) caller for $5.9 (now $21) – my worst spread so far… I think it can easily pull back to around $140 between now and expiration. When to roll? And to what?

    The Solution: SHLD – Did I really say to sell the $125? I can’t imagine because I was buying them… Anyway, he is doing you no good at all down there and if taking the hit and rolling him to the Nov $140s for $11.20 doesn’t suit you then I would bite the bullet and roll yourself to 2x the Mar $145s at $17 (+4 per current share from you) and roll him to 2x the Nov $140s at $8.15 (+ $5 per current contract). The money you put in is less than the margin you are currently carrying and it puts him out of the money, effectively picking up $22 in position and premium at the cost of 10 of your months – but you can always roll back to your original position once you wipe him out.

    If you have deep pockets (and I assume you do from the spread) then you may want to consider simply rolling him to the $145s for now to collect that $4 in premium, THEN either roll him down to the $140s to collect another $2 or $3 if it goes down or over to the same Nov $145s or $150s if starts going up again.

    The problem: I am long the CCJ JAN 2008 40 Call @ $7.38 (adjusted cost basis) now $7.70 and short the CCJ OCT 40 Call @ $3.76 now $5.90. It seems I have let it get away from me. Is there any way to salvage this one?

    CCJ – the way they go up and down I wouldn’t want to jump in and out. There are 2 good exits but once you see them you’ll know there’s no rush (but you do want to catch them while you’re above $45). You can roll yourself to either 2x the Dec $45s at $4.15 or 2x the Jan $47.50s at $3.60 and roll your caller to 2X the Oct $45s at $2.30. That throws your caller out of the money, holds good coverage against your position with $1.80 in premium and gives you less downside delta compared to your caller. Of the 2, I would stick to the Jans but that depends on your margin availability.

    The Problem: I have a question about the rolling of my callers and my own position as I move deeper into the money. This specific question concerns Apple. I have some ITM Leaps (120’s and 130’s) and am short the 140’s. There seems to be a general strategy of rolling up 2X the Leaps and selling 2X the near term calls. But I look at the April AAPL 140 calls that I am short and they closed at $11.50 of which $2.00 is premium. At the same time, I look at the May 150 calls and they are $10.00 of which $10.00 is premium. Why isn’t it the correct move to just close out the 140’s and pay a $1.50 for the 150’s which have so much premium. And keep the ITM Leaps?
    The Solution (discussion): Both strategies are valid and very much depend on your goals. With leaps you have lots of time so you will simply roll to May, the 2x strategy is valid when it works and your caller is suddenly deep in the money but let’s say you have Jan $120s at $42 and you sold the $130s for $5, now $20. Rather than try to roll the caller to May $135s for $19 or spending $5 to roll them to the May $140s, you can roll your caller up to 2x the $145s atr $8 (costing you $4) and roll your Jan $120s to 2x the Oct $140s at $25, costing you $8. Effectively, rather than give your caller $14 you owe him, you are spending $12 and giving up some time and position in exchange for doubling you long calls and collecting another $7 in April premium.

    The bottom line is that the roll to the May $135s would yeild $4.50 in premium, not totally off plan but uncomfortably deep in the money to start the month (assuming you remain bullish). The leaps are deep in the money too and locking up a lot of capital for a small return so the net equation is you are taking $42, from which you would have to spend $4 to get your next $4.50 in May premium and exchanging it for $50 worth of October calls from which you will spend $4 to get $7 April premium and another $10 in May premium. Over the same 6 week period, your extra $8 yields $13 in additional premium and, since the 4 remaining months (June-September) will now yeild double premiums, the trade-off from the January calls, which had 7 sales remaining, works out better than even for you.

    You have also lowered your downside delta by getting out of the $120s but this would still be a bullish posture on Apple as you stand to lose $15 in premium x 2 vs the $13 total premiums on the $120s. All these things need to be taken into account when you look at your rolls but, during the day, I usually say “Just roll to 2x the Oct $140s and roll the caller to 2x the $140s” when someone asks me.

  2. Rolling short calls on aggressive gainers

    Question: – I have 10 contract aapl Apr08 $160/Oct $155 call spread that is positive $1,500. time to roll the oct’s. what should i roll to? the $155’s or the $160’s?? what is the reasoning i should employ here???

    Phil answers: – AAPL Apr/Oct – Ah, that’s better. Well it doesn’t look like they’re ever going down so you have to just play them for the long haul and roll him up to the Nov $160s, roughly even. Wost case, if you pick up $5 a month between now and April, you’ll be selling him the March $180s for $13 and you’ll be $30 in the money! You could take a chance and move to 2x the Jan $170s ($17) and sell him 2x the Nov $170s ($11) to turn him into a pure premium play and take $9 per current contract off the table while still leaving yourself 65% covered with 2 months between you.

    Rolling really big gainers

    We roll based on the outlook but, obviously, there are also financial considerations. If you get smoked on a GOOG $620 caller (we did) and the stock goes to $685, while it may be prudent to roll them to the $670s for $23, not many people can afford to come up with $37 out of pocket to do it. In a case like that, you may have to roll him even to a Dec $630 and a Jan $640… until you run into your leap, which will be very deep in the money by then.

    Ideally, on each roll, you want to put your caller into whatever call you would want to sell if you were entering the position from scratch but, if your leap is deep in the money, you need to lean more to protection when choosing a caller. At a certain point, you need to adjust the entire position, as we were just discussing re. MSFT.

  3. Managing Long Calls

    Motivations to roll down LEAPs

    Be careful as your leaps are benefitting from a higher VIX – that’s why we roll down with our callers as we get the full benefit of a rebound as it becomes more intrinsic for us.

    Watching Margin as well as Position

    GS – I prefer the BSC Jan ‘10 $110s for $24.25 against which you can sell the $115s for $3.50 (but waiting for a bounce). On the GS, absolutely when you get way ahead early you want to take out your caller (with stops) or roll him down to one with a bigger premium if you don’t think it’s going to bounce. In GS’s case, it looks like this may turn into a real rebound so maybe see how they do around $175 before reselling. Also, whenever you take out a caller, one of the things you should consider first is should you be rolling yourself down to a tighter call, it reduces your margin requirements and increases your leap’s Delta so a strong rebound won’t burn you as badly when you have callers.

    If your leap is the ‘09 $195, it costs you just $5 to move to the $180s or $7 to go to the $175s from where you can sell the current $180s for $3.85 vs selling the $195s for .80. Effectively you will repay the cost of the roll after just 2 sales.

    Rolling end months – the new bet

    Rolling, usually I do it with 10 trading days to expiration. I really try not to hold any current months into expiration week unless I’m looking for very specific mo.

    A roll assumes I still believe in the fundamentals but the timing was bad. Don’t fool yourself it’s really a new bet but for me, treating it like the same bet and carrying forward my loss by adjusting my new basis up keeps me realistic about my expectations. I treat rolls with DD rules (get 1/2 out as soon as you get even) since they almost always require an addional investment – so yes, I put more in, usually at least to match the original number of shares.

    Rule of Thumb for paying for rolls
    SNDK – yes for $3.60 (my rule of thumb is take a $10 roll for $3.50)

    Paying for position – I usually will pay $3.50 or less for $10 in position over 30+ days (and $1.65 for $5) to roll close to the money (on volatile stocks of course).

  4. Pre-Rolling Long Calls


    Pre-roll is establishing a position that is either further out of the money or further out in time than your existing position with the intention of tightening up the stops and eventually taking you closer to the money or in the money play off the table to protect your profits.

    The real difference between a pre-roll and a roll is that the pre-roll is a bit of a gamble as we intend to keep both postions open but, obviously, the sooner you get in, the less you will spend so we do this when we have a very strong feeling of direction.

    Some examples of pre-rolls. Note in the HAL discussion that there is a bird-in-the-hand rule on pre-rolls, and in the MST discussion there is a similarity between pre-rolls and mattress plays.

    Example: A pre roll is a position (like we just did with JPM) that I am so positive will succeed that I buy the position (the Oct $45s) AND the position I want to roll it to (the Oct $47.50s) at the same time. That way I spent just .50 for the $47.50s and, as soon as my primary position made .50 I set a tight stop on it to guarantee a free ride on the remaining position. In the case of JPM, we took the $45s off the table with a huge profit and they remainder is all gravy. So in short, a pre-roll is buying the position I want to roll to before I want to actually roll out of the main position. It is, of course, doubling down on your bet but, when done right, it’s a very graceful way to exit a winner without giving up additional profits.

    HAL Pre-roll – I took some Apr $32.5’s calls yesterday at .35 and some $35’s for .10. Going to scale back the $32.5’s and let the $35’s ride for a gamble.

    HAL – I call the $35s a “pre-roll” in that situation and the thing about a pre-roll is that you are supposed to take ALL of your in-the-money contracts off the table and then set stops on the rolls to lock in the profits you do have. As a rule of thumb, as soon as I get a double on the lower calls I get out and set a stop at 50% of my “free” remaining calls. So in your particular case I would take .70 off the table and set a stop at .05 on the $35s. If it goes to $35 you will still get a buck or so for the $35s (assuming it happens soon) vs. the extra $1.80 you could have gotten on the $32.50s but, going the other way, you could blow a double and lose all of the $35s and both postions will absolutely lose value if the stock does not break higher so you are making the most logical choice for the situation.

    Literally, a bird in the hand is worth 2 in the bush.

    Pre-rolls with close-bracketed stocks

    With a close bracketed stock like MSFT ($2.50 increments) there’s a lot to be said for taking a pre-roll. In your case it would the $32.50s for $1.73. You can sell 1/3 of yours and buy them to match up or add new funds but once you own them you can then sell the current $30s for $1.81 against your Apr $30s which is plenty of money to cover both sets for anything but a terrible drop while your naked $32.50s give you plenty of room for additional gains to the upside. Going back to the mattress concept, if MSFT takes off and runs over $32.50 you will be able to roll your $30s up to 2x the $32.50s and then roll your caller up to 2X the Dec $32.50s to lock in those gains and push him into premiums.

  5. Applied Mattressing Tactics

    Mattressing with Google

    GOOG strangle – sold 1/2 the $600 puts to buy the $650 calls for $8.20, pocketing $2 which brings the cost of the whole trade down to $4 for a $650 call/600 put spread. Now the rule is to spend $2.50 to tighten by $10 in whichever direction I get a chance. If GOOG starts to run in one direction or the other, I follow the mattress strategy of buying the next position that cost $4 within 2 brackets ($20) and then setting tight stops and rolling out of the higher contract, then tighten again (for $4 total) if it goes the other way.

    Focus puts are another application of Mattressing tactics:

    Focus Put Approach

    C puts – not my favorite but I do like the general idea of focus puts (mine at the moment is XOM) which you simply make a decision that you will roll and roll and roll and roll until you are right. As long as you keep it a reasonable position as a hedge against profits and as long as your premise is intact (if the Dow goes, they should go down hard for example) then putting a little more money in once in a while is fine. I had an unrealized loss of $160K on one of my DIA puts wich I’ve been doing that on. Today it gained $40K on just this little drop. It’s a terrible strategy if you run out of conviction OR resources but it’s a fun way to play a volatile market as long as you can control your emotions.

    Focus Put Mindset

    BIDU – one more roll up (if I get my $3.50) and then follow plan to roll to Dec. I would be happy to go through that with anyone who wants to save it if we have to on Mon. Remember LVS, UTHR, WYNN, XOM… following Focus puts or calls means keeping at them until they break – that’s why we follow them as anti plays to the direction we are going. The more you make, they more you bet on this particular stock breaking.

    Focus Put XOM Example

    Speaking of plays – it’s time to buy some XOM Apr $80 calls for $2.25. Yes CALLS. This is part of a spread for those of us that have money on the downside already but can be taken in conjunction with the Apr $70 puts for $1.60. A $5 move in XOM in the next 3 months will put you in the money!

    I’m taking it protectively to cover 25% of my open oil put positions (rather than take profits) and will happily DD as my puts go further into the money (increasing my coverage for less money). I think these will be slow to fall (look how many die hard oil bulls there are) and they trade up at about 40% to XOMs move but that increases as you get closer to the money.

  6. Covers

    Covering downside with calls

    There is nothing wrong with grabbing calls as a mo play when you have heavy bets to the downside. Selling a position you believe in isn’t necessary but covering it is. Unless you are intending to roll up your puts to follow the marker all you lose is some spread and commission by, for example having $50,000 worth of puts, then the market goes up 100pts and you grab 25,000 worth of DIA calls at the current price (just in the money). If the market goes up another 100, you gain $25K (about) if the market goes up 50 and then reverses and goes down 25, before you feel comforable letting go of your call insurance, then the amount you are out is likely to be less than the amount you recover on your existing puts. If it starts going right down when you buy it, then you say, thank goodness that was the top, dump them and lose $2K but at least you were able to ride out the spike… See Optrader’s comment @ 1:02 for the right attitude!

    Adjustments and mindset for covers

    PESPECTIVE – the IBM cover is not a loss. When IBM fell to $115.50 the Oct $115 call dropped to $4.80 (down 20%) and I needed to decide to DD (not palatable with 20 shares in already) roll it (I was no longer confident enough to put more money in) or kill the trade (I still liked it). So I chose none of the above and arrested my losses by selling the current $115 calls for $2.40. Now the stock has come back and looks healthy with my calls back at $5.60 and the calls I sold ran up to $3.40 so my insurance (and, again, had I played it to plan it would be better) cost me .20 per contract or $400 to make sure I didn’t lose another $2,000 by leaving IBM naked after a very poor 2 day’s performance. Not to pick on him but ask Sahaida if he doesn’t wish he had done that when things were not going his way…

    When a boxer is getting hit, he may take a break by putting up both hands and letting his opponent hit him in the arms. While he can’t possibly win from that posture and it costs him some points, it does gives him a valuable rest and a chance to regroup his thoughts while he tries to recover. It’s a matter of survival – shouldn’t you give your positions the same chance once in a while?

    Oil covers are a special case of advanced tactics. Since Phil is shorting oil a lot lately (why? heck, I dunno), that makes the main position a Focus Put, and means that covering is a matter of selecting the correct upside play to protect the puts against unexpected or unjustified bull moves (oil? manipulation? nah).

    Oil Covers

    Oil covers – effectively you need to be on the 60/40 rule for a cover against your preferred direction. Ideally a cover should be longer or closer to the money than your puts so that you are not forced to dump it on a quick move. Your main goal is to be revenue neutral if you get a big gap up or down but to be able to ease out of whichever side isn’t working. I like my covers to be in big, liquid plays as you have to make very fast decisions sometimes.

    For example, for every oil contract on the downside, I have 2 XOM $80s, which move about .15 for every dollar of XOM movement. Since I expect XOM to move up pretty much in line with oil, then a $2 gap up should give me about .60 (2x) protection on my existing puts. I don’t ususally cover this way but I’ve been using these same calls since January and DD’d every time XOM dropped and sold 1/2 every time I got even until I ended up with 200 and a basis of just .15 (I just sold 200 today at .35).

    I should have bought more last week for .05 but I thought oil was done then – hopefully it’s really done now. Either way the idea is to be NEUTRAL on a move against you, or at least close to it. The cover is there to protect you overnight or through any uncertain period but needs to be quickly removed when things go your way.

    This is a very tricky, day trady, momentum thing to do and takes a lot of practice because you can trade yourself right out of a profit if you overdo it. I will ask Sage if he has a good primer for using covers as he is very good at teaching basics on that kind of thing.

  7. Special Considerations

    Note Phil managing the premium he pays for his long side going into earnings.
    ORCL spread for earnings

    I don’t want to buy the Jan $17.50s because they cost $1.20 so I’m paying a .60 premium into earnings and they might get wiped out at the bell tomorrow and I’ll have no chance to recover. The March $17s are $1.90, a .90 premium and if the stock drops $2 they are likely to retain about half their value. By selling the $17.50s against them I’m cutting my basis to .80 on the March $17s and, no matter how high the stock goes, I have a 3 month and .50 advantage over my caller. If it goes way down – I am out whatever off the .80 but I still have 2 months to hope for a recovery and now caller to pay off at all.

    Too complicated even to begin on, it’s a trade based on the simple observation that DNDN periodically rockets to a double or triple of the stock price. Phil writes a full essay about a way to take the play that is still valid as of today (Nov. 14). Read the whole series:
    Part I
    Part II