Sunday, July 4, 2010

Hedging with Calendars

In last week's Rollin with My Puts post, we reviewed rolling long SPY puts into verticals to partially hedge against a rally in the SPY. Today's post explores another alternative worth considering - rolling into calendars. Within the post the intial trade was outlined as follows:

"Suppose we purchased a SPY August 110 put option for $4.50 on June 23rd when the SPY was trading around $109. Given the precipitous fall in the market coupled with the sharp volatility surge over the last week, the put option has risen in value giving us a $280 unrealized gain."

Consider the position's risk graph below (click image to enlarge):

[Source: MachTrader]

Since last Wednesday, the put has further increased $150 placing the current unrealized gain around $430. Instead of shorting a lower strike Aug put against our position (rolling to a vertical), how about selling a July put? Suppose we sell the July 102 put for $2.15. Consider the new position's risk graph with the change in delta, theta, and vega:

Per the delta, the directional exposure was cut in half from -77 to -30. Theta has flipped from negative to positive, making the passage of time now a benefit to the trade. Finally, the trades exposure to volatility has been notably reduced as shown by the lower position Vega.

In summary, traders holding profitable put positions may consider rolling to verticals or calendars when wanting to hedge their risk against an adverse move. Whether the short option provides a large or small hedge is largely dependent on the strike price you choose to sell. In today's example we opted to sell a put eight strikes below the long put option (102 vs. 110). Where we seeking a larger hedge we may have considered selling a higher strike put such as the 104 or 105. Risk graphs prove quite effective when analyzing the net effect of selling one strike versus another. Be sure to use them as needed.

For related posts, readers can check out:
Adjustment Trading and the Salvation Syndrome
Utility of a Risk Graph
Graphing an Option's Evolution