Trading Option Backspreads (Minyanville Media) by Adam Warner

Author:Adam Warner [Warner, Adam]
Language: eng
Format: azw3
Publisher: Pearson Education
Published: 2011-09-13T04:00:00+00:00

Defensive Hedging

The above hedge refers to the times you have positive gamma and want to offset the resulting costs. But time and price on this trade can give you negative gamma and reverse the whole equation.

In this next chart, you see gamma at various price and time points.

In a vacuum, the $82.50 to $85 range works well for this trade. You collect the entirety of the premiums you took in. That’s a relatively small dollar amount though, $440 total.

Let’s say that you closed any stock positions initiated against your long gamma. And now it’s expiration week and XOM trades in the low 80’s, putting both the 77.50 puts and 90 calls out of play. What to do?

You now have a short strangle on, short the expiring 82.50 puts and the 90 calls four times each. If XOM expires over $85, you will get assigned on the four calls. So what if on Wednesday XOM sits near $86? You probably need to either buy XOM stock or buy a call or three back to defend the position. Let’s say you buy 100 shares at $86. What now?

Case 1: XOM continues to grind higher. Good thing you bought a little, but you have to buy more. Not good. You only had a $440 premium cushion to begin with, plus potentially some stock trading profits over the course of the trade against the temporary long gamma. But if XOM’s now $87, you lost two points on the four short calls, or $800. Against that you earned $100 on the stock purchase at $86, plus the original $440 premium cushion. Not to mention you still might have to chase XOM on 200 more shares. You have the wind in your face in this situation.

Case 2: XOM turns back around and goes under $85. You made a poor purchase at $86. And with XOM under $85, you don’t need it any more as you won’t get assigned on your calls. So you should probably sell and take your loss on the 100 shares. Suppose you sell at $84.50, or a $150 loss. That’s about 1/3 of your premium gain, so you can afford it and still win. But what if you get caught poorly flipping a few times? Or instead of losing $1.50 we lose $2.50. That’s known as the “whipsaw.” Your premium cushion can only absorb so much before the trade turns red.

Bottom line: With negative gamma, you try to lose less in poor stock flipping than you take in earning daily decay. This is always easier said than done.

An alternative: If expiration approaches and XOM sits in this price range, close out the trade. Remember the original goal of the trade, and make sure the natural progression of the position does not result in some extreme drift. You originally entered to trade as a low cost way to play for a big move, with a small kicker that you earn a little premium if XOM flatlines. Well, XOM flatlined and you earned your small premium.

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