Option Sage Submits:
When driving a car and some object appears on the road ahead do you usually run right over it or do your best to avoid it?
Don’t we all take action in real-life based on the new information we receive that changes the old paradigm? Take the first two guys in this video: Who would you rather be, the first or the second guy? While the second gentleman reacts and looks ridiculous in so doing, he’s the guy that is more likely to survive when real disaster hits because he’s reacting to new information. In fact he doesn’t even know what’s making everyone else react, he just knows that when 99% are moving one way in panic, it’s best not to fight the crowd or he will be trampled. It’s no different in the market. Pride, ego and old theses have no place when new information directly contradicts an existing trade.
This week, we used DIA and QQQ puts and calls to "react" to quick changes in the market while we waited for better information before making more permanent changes in our positions. This gave us the benefit of the quick reaction of gentleman #2, the one who went unquestioningly with the crowd, while also giving us the "wisdom" of gentleman #1, who was confident (or oblivious) enough to soldier onward, despite the fact that the world seemed briefly to be against him.
When new information does arrive, one of the first things I look to do is minimize risk – hedging the existing position. The next step for me is to become more aggressive in reacting to the new information and shifting the bias of the trade in the opposite direction. In this article, I will outline a map that you can use to convert from one strategy to another, based on changes in outlook arising from new information.
The conversions outlined can be applied also when you know that you will be unable to monitor your positions. For example, starting with all the July 4th parties occurring this next week, many of you will likely be taking vacations and. with them, a break from actively monitoring your positions. With that in mind, it’s always prudent to protect your positions from the “just in case” events that can derail your positions in a flash when you are not attending to them. Those “just in case” events are a reason to remain nimble and flexible when trading the stock market as opposed to becoming emotionally tied to any single position.
Without further ado, let’s look at the potential positions you may have in the market and discuss some possible conversions to more neutral trades that will reduce account fluctuations. Remember, the point is not to "win" these trades; the idea is to bet against yourself, putting your folder in "neutral" while you head off to the Bahamas for 2 weeks. You may lose time value on both ends of your trade but often this is less than the cost of jumping in and out of positions. You paid for your vacation – adding a hedge is just another travel cost that let’s you really enjoy it without worrying about your virtual portfolio!
*** Note, these are examples of hedges, NOT recommended trades for this week. ***
Long Call > Straddle/Strangle
Long Call > Call Calendar / Bull Call Calendar / Bear Call Calendar
Long Put > Straddle/Strangle
Long Put > Put Calendar / Bull Put Calendar / Bear Put Calendar
Bear Put (Long put with a short put at a lower strike) > Put Calendar / Bull Put
Bull Call (Long call with a short call at a higher strike) > Call Calendar / Bear Call
Bull Put (Short put with a long put at a lower strike) > Ratio Put Backspread / Collar Trade
Bear Call (Short Call with a long call at a higher strike) > Ratio Call Backspread / Synthetic Strangle
If you already have a collar trade, a straddle/strangle or an advanced strategy such as a ratio backspread in play then you are likely so well-hedged that you can ride through any volatility that ensues without too much account value fluctuation.
For those of you that tend to be more active, I would encourage you to read up on Phil’s mattress plays and consider trading index puts against existing positions. Personally, when I consider those plays I like to buy 1 put contract for every 100 shares of stock and 1 call contract. For technology shares, I purchase QQQs. For Dow stocks, I purchase DIAs as hedges and so forth. Phil tends to focus on the index that is likely to snap back the most on a correction which is another great way to insure your positions and often more profitable (assuming you are good at doing your homework – which of course we know he is!).
Happy 4th of July!