A few weeks ago, we received a request about using put spreads for hedging. Since our last comments on spreads are more than a year old and market conditions have changed this seems like a good time for an update, but first, a brief note about our usual Market Review. Last week the S&P 500 Index made multiple new closing and intraday highs while our tactical indicators improved slightly and remained quite bullish. Last Monday's Digest Issue 6 "Don't Worry, Be Happy [Charts]" continues doing a good job describing the current condition.

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Option Spreads

First some common terminology. When completed with a debit, the practice is to refer to a spread as a long position. Alternatively, when completed for a credit it's called a short position.

Initially attracted by the advantage of leveraging small commitments with the potential for large gains, single option positions also come with additional risk beyond getting the direction right. Since options expire, they continuously decline in value and the closer to the expiration the more rapid the time decay. In addition, option values change as implied volatility changes.

Spreads greatly reduce both time decay and volatility risk while maintaining the direction opportunity. Further, they define the risk while also limiting potential gains.

Referring to options characteristics, commonly called the "Greeks," some have positive values, others such as time value or "theta" have negative values. By combining a long option with a short option the positive and negative values are partially offset depending upon the "moneyness" or the amount the strike prices are in, at, or out-of-the-money. Of course, spreads can have more than two legs in various ratios such as 1:2, or 2:3 or other combinations that significantly alter the "Greeks" and the risk profiles.

Using 1:1 spreads for direction trades or hedging existing long positions, allows the initial debit or credit to be limited and defined while the maximum potential value can be calculated based on the distance between the strike prices of the legs. For bullish call spreads or bearish put spreads, a debit of about one-third of the distance between the strike prices makes a reasonable guideline and will typically be found using out-of-the-money strike prices.

Generally, for pricing spreads with actively traded options, when buying, use the ask of the higher priced leg, less the mid price for the second (or more legs). When selling, use the bid for the lower priced leg plus the mid price for the upper leg. Stocks and ETFs with low option volume and wide indicated bid/ask prices, may require using the ask for the buy leg and bid for the sell leg when buying a spread, and bid for the buy leg and ask for the sell leg when selling a spread and the price difference can be substantial when opening and again when closing the position. For this reason look for stocks and ETFs with high options volume and narrow bid/ask prices.  

Put Spreads For Hedging

Long put spreads also called vertical put spreads.

Assuming an active stock or ETFs with options volume of at least 100K contracts traded daily select an out-of-the-money put with delta around -.35 as the long leg, then select another further out-of-the-money put with a delta around +.25 as the short leg (since the option has negative delta the sale turns it positive). Using the ask for the long and the mid for the short the debit should ideally be about 30% to 35% of the width of the spread. Typically, put spreads will have a slight implied volatility edge since the short option will have higher implied volatility, so compare the implied volatility of each leg.

Selecting the expiration date depends on the reason for opening the position. Perhaps hedging an earnings report, or some other event or maybe deteriorating market conditions. Spreads closer to expiration cost less, but also have a lower probability of success. Typically, spreads with more time to expiration allow more flexibility to make adjustments or even close early for a loss if no longer needed. Use around 60 days as a guideline. 

Hedges opened early at the first sign of trouble have an advantage since they cost less before implied volatility begins to accelerate. If no longer needed consider the loss like the cost of insurance with the ability to cancel the policy early.

Once downturn momentum accelerates, consider adding more spreads or even a put ratio spread consisting of one short put near the money with two long puts out-of-the-money.

Upside Spreads

Long call spreads also called vertical call spreads.

Rather than hedging the downside use call spreads to participate in advances while limiting and defining the risk. Use the same selection criteria, especially the time to expiration since upside expectations have tendency to be overly optimistic. With the intention of staying in the game while recognizing losses are inevitable, the ability to limit and define risk becomes necessary.

To plan strategies and better understand position risk try using an options strategy planner that allows multiple option legs with or without stock or ETFs along with ability to change implied volatility assumptions to model various combinations. Information about our Live PnL Calculator designed for this exact purpose follows.

Changing Market

Recently the OCC, the largest equity derivatives clearing organization announced January 2021 total cleared contract volume increased 61.7% to the highest month on record, compared to January 2020.

An ongoing bull market combined with changes to brokerage commissions are two likely reasons. Traders no longer concerned with commission costs now open and close option and stock positions more frequently as reflected by the records. 

For example, consider straddles that adjust back to neutral with stock over the term of the position. Perhaps implied volatility declined back to its mean for the last year after the company reported earnings a few weeks ago. A look at the chart shows implied regularly advances by 20% or more into the next report date. You consider a long straddle, that is buying an at-the-money call and an at-the-money put starting the position delta neural. The plan is to close it before the next earnings report when implied volatility nears the pre-reporting peak. After checking our records for the last time we tried this strategy, we see it was only slightly positive after making six stock adjustments to return it to delta neutral. Due to all the trading and record keeping, we decided at that time it was not worth the effort and moved on to other strategies. Looking back if the stock adjustment trades had been commission-free the results would have been dramatically better.

Use the same stock adjustment process for a short straddle, selling an at-the-money call with an at-the-money put for a credit when implied volatility nears a peak, typically the day before reporting earnings. Check the volatility chart to evaluate the probability it will make a substantial decline after reporting just as it did for the last few quarters.

Long and short straddles are just two examples of how commission-free trading boosts both stock and option volume. There are many more.

Strategy

In bull markets, the best strategy is to stay long equities and/or ETFs and then tactically hedge pullbacks as they begin developing since ordinary pullbacks can become corrections when something unexpected happens. Then corrections can become downturns when something else unexpected happens, and downturns can become bear markets when many unexpected things change medium and long-term fundamentals.

Summary

Futures and option indicators remained bullish enough last week to extend our declaration to "Don't Worry, Be Happy" for at least another week.

Consider using option spreads to help define and limit risk.