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

One of the most important lessons we teach at PSW is hedging.

Hedging means many things but generally, it’s betting against yourself. 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.

The less you think you can be wrong, the harder it is to hedge. This is where traders can get themselves into trouble, especially in a prolonged bull market or a bubble, where risk is rewarded and caution is relatively punished. I mentioned in the previous post that I am always hedged. For me, being 100% bullish means I have a 70/30 balance of bullish to bearish positions, perhaps 80/20 on a run but almost never overnight.

Do I miss out on big gains with that strategy? Of course I do! Do I miss out on big losses with that strategy? Of course I do!

Here’s some very annoying Sunday math:

On 9/18 Mr. Unhedged Investor buys 100 DIA November $137s for $4 ($40,000). This turns out to be a great trade as the Dow flies up and, by October 2nd, the calls are up 50% to $6 – a $20,000 profit. If he were a PSW member, he would have cashed out at least 1/2 on the first dip to $5.50 and locked in a 37.5% gain but let’s assume he was greedy and let it ride as the contract bounced between $5 and $6 between October 1st and the 12th.

On Monday (10/15) he wakes up and the contract is at $4.75. This is a tough call for the guy because he has until November and he was just up 50% (on paper!) and taking less than 20% now seems pointless and Cramer says it’s just a bunch of pansies taking profits before the bulls take it higher. Tuesday the Dow drops again and the contracts hit $4.25 and Wednesday, even though the Dow opens higher, the contracts never break $4.25 and sink down to $3.50 by the days end. On Thursday, he should be happy to take $4 off the table when it’s offered but now he’s sure it’s a comeback and that 50% is just around the corner. Friday the market drops and the $137 contract opens at $3.25 and, if he doesn’t accept defeat within 5 minutes of the open, it’s $3, then $2.75 (held until noon) then a close at $2, down 50% from the purchase and down $40,000 from the top. Ouch!

If this sounds horribly familiar, then you must be an options trader!

On 9/18 Mr. Hedged Investor buys 100 DIA November $137s for $4 ($40,000). The next day the contract is at $5 (up 25%) and our rules here are simple. Set a stop at 20% or hedge. Since this is an article about hedging, we’ll assume he chose to hedge… So, with a profit of $10,000 and the DIAs at $138, Hedged Investor buys (and we have rules for this too!) 10 Nov $136 puts for $2.75 ($2,750).

Both positions went up and down a bit until the big move on October 1st when the Dow jumped to 14,000 again and the Nov $137 calls went to $6. The contracts were now worth $60,000 and the 10 Nov $136 puts fell to $1.50 (-$1,250) for a total of $58,750 vs. the $60K that would have been on paper in an unhedged position. Since we are now up $18,750, we need to take $6,000 and add to our hedge.

With the DIA at 14,050 on 10/1, the $136s seem too far out of the money so we roll the position up to the Nov $138 puts at $2, which costs us .50 x 10 contracts for the roll ($500) and we spend another $5,000 to buy 25 more contracts at $2, bringing our hedged spending up to $8,250 for 35 Nov $138 puts. Since our main contract bounces between $5 and $6 from 10/1-10/12, let’s assume we do the same nothing (although, as our members are well aware, we would have rolled much tighter to take advantage of a cheap strangle opportunity with 6 weeks to go).

On Monday (10/15) we wake up and the Nov $137 calls drop to $4.75. This is terrible BUT our puts jump to $2.25, somewhat mitigating our loss. Even if you assume the same terrible decision making process as our Unhedged Investor for the week, the bottom line is that at the end of the Day on Friday the Nov $138 puts were worth $4.25 or $14,875, up $6,625. Instead of a 50% loss on $40,000 invested originally, we have a 33% loss – still not great but this was very poorly played…

At the very top, our hedging cost us $1,250 out of $20,000 (6%) of our maximum profits (but we didn’t know it was the maximum did we?). At the very bottom, our hedging saved us $6,625, or 1/3 of our losses and we didn’t have to be smart, we didn’t have to call a turn, we didn’t have to take any action. All we did was trade in a small percentage of our maximum gain in exchange for a large decrease in our maximum loss!

As I said, this was a very poorly played example.

We sold our own DIA Oct $139s on 10/2 and we let our QQQQ Oct $139 calls ride until the 3rd and we were never motivated to go back into long index positions. As I mentioned in the previous post, when the market is very toppy like this, we don’t bet against our own positions but we pick "Focus Puts," taking positions against stocks that we feel are due for a nice correction – giving us more bang for the buck hopefully.

We’ve gone through very successful put plays on BIDU, DRYS, RIMM, XOM, PTR, FXI, COP, VNO and BXP this month, stocks that broke down despite the rally. This is not a bet against the companies in particular, just against their extended valuations on certain days. There are, of course, permanently bad stocks we short into any run like GM, WFMI and LVS but none of those made our focus list this month because the timing didn’t seem quite right (although we did make little plays on LVS and GM anyway).

Still, no matter what the market, with over 100 different call positions open in our virtual portfolios, we find it prudent to always have an index put or two to hedge the overall put/call imbalances in the virtual portfolio "just in case." If you are asking "just in case of what" then you must have missed Friday completely! The purpose of the index puts is not to make money, although that happens by accident sometimes. The index puts are there to give us time, in a dip, to calmly evaluate our open positions so we can decide, item by item, whether to Stop (take it off the table), Drop (drop our option to a lower strike) or Roll (move our calls to a lower strike or farther out in time).

Yesterday was one of those times we accidentally made money on index puts. Well, accident is a strong word. I often say that winning in options is about being in the right place at the right time. You have to get both the strike and the timing right to "win" with an option contract – if you miss either, you often get nothing for your troubles. Our general index hedging strategy is summed up in my March 5th article "The Stock Market Parachute" which outlines what we refer to as "mattress plays." These are the plays, as in the above example, that (if nothing else) cost us 6-10% of our potential gains while eliminating 33% of our worst losses. It’s a trade I make month after month after month with few regrets. By constantly rolling our index puts with a fixed percentage of our winnings, we make sure we’re always in the right place as we wait patiently for the right time to come along.

Again I will say that even if I were to ultimately lose 10% of my gains, 15% of my gains, 20% of my gains… I would still make these plays as they let me sleep at night and, from a practical standpoint, they let me keep my winners in play as I have less fear they will be taken away from me. So, in a raging bull market, my gains compound in ways they wouldn’t if I felt compelled to take profits in an unhedged virtual portfolio.

We did start Friday with 200 QQQQ Dec $53 calls because we stopped out of our October $53 caller on Tuesday’s bounce. Those came off the table with a slight loss in the morning (because, unlike the earlier examples, we do have the good sense to use stops) but a win on the adjusted basis (as we made .50 on the caller). That left us with 150 DIA Nov $140 puts at $2.88, basis $2.40 and 400 DIA Nov $142 puts at $4, basis $6.35 (as they had been rolled for a loss many times) in the Short-Term Virtual Portfolio. There were also 100 DIA puts in the Dow Virtual Portfolio and 100 QQQQ puts in the LTP but, for simplicity’s sake, we’ll focus on the STP positions:

The 150 DIA Nov $140 puts were our recent addition from 10/15 while the older $143 puts were from way back on 9/7 and had begun their lives as a group of Sept and Oct $131 and $132 puts that we consolidated into 400 Oct $140 puts at $5.55 (down 50% at the time). Over the past few weeks, we’ve spent .35-.40 whenever we could to roll up to a higher put, raising the base cost of what was 400 Oct $140 puts to 400 Nov $143 puts at $6.35 (there were some small gains along the way and we sold September calls against them to reduce the basis, very complicated).

This is what we do to protect our positions, we look at how much money we have to spend on the put side and decide if that money is best used to add to the current puts, roll them to a higher position or go further out in time. Since we ALWAYS buy protection (like life insurance) we treat it more like a running expense than a position we are trying to "win." Since we had been having an exceptional month, the 400 Nov $142 puts at $4 were worth $160,000 on Friday evening and were down $94,000 while the 150 Nov $140 puts were at $43,200 – a slight profit.

On this particular Friday we were lucky as we saw this drop coming from a mile away and had already pulled our calls or we would have been much too busy to have fun. Because we were in the right place, and it was finally the right time – we were able to have lots of fun!

Although we were very distracted by Google in the morning at 10:34 I said: "It looks to me like Apple and the Brokers are heading south, if GOOG goes negative too we could be in for a MAJOR drop. 4 declines to 1 advance and we are blowing supports. 2,760 was critical on the Nas, the Dow and the S&P already fell apart and the SOX look sad, sad sad, so we need to cover more than we planned. Go tighter when you can and let’s mattress the DIA puts with the Nov $136 puts at $2 with a .30 stop (cheaper than buying the current $137 puts and having them expire worthless). XXX" I was way too optimistic as the current $137 puts finished the day at $1.98 but, what can you do? Per normal mattress rules, we picked up 300 Nov $136 puts at an average cost of $2.18 – they never touched $2 again.

So that’s 400 Nov $142 puts, 150 Nov $140 puts and 300 Nov $136 puts which (per other rules we follow) I rolled up to the Nov $137 puts for .35 more per contract.

Although we were well covered to the downside, at 11:18 I made a cash call to get winners off the table. That took out most of our uncovered calls and left us with a lot of naked puts. At 11:33 I said: "Nasdaq broke 2,760, which it had been holding and now we have to watch for 2,750, which was my original breakout level. Don’t forget to layer mattress puts with whichever Nov DIA put gets to $2, set a .25 stop on the ones above it and a .25 stop on that one too at this point because it’s getting to be a lot of money!"

That led to the immediate addition of 300 DIA Nov $135 puts at $2 (never dropped a quarter). At 1:40 the market held flat well enough that I decided to get the Nov $142 puts off the table but didn’t get my price (I wanted my $6.35 back) but I did get $4.50 for the Nov $140 puts, close enough to a double not to be greedy. I called for a DD on the $137 puts at $2.70 to make those our main position and I ended up covering my Nov $142 puts by selling the $135 Nov puts at the close (along with the ones I already owned) for $2.75 with the intent of rolling over to Dec next week (remember, unlike 42M Americans, we ALWAYS have insurance!).

So that’s 400 Nov $142 puts at $6.35, 600 Nov $137 puts at $2.61 and 300 $135 puts for $2.

At 2:23 I called the next leg down in the market saying: "There goes 2,750 on the Nas, S&P doomed below 1,515, Dow unlikely to hold 13,600 and then a test of 13,500 and my 380 drop." At 3:03 I made a call to take 1/2 the puts off the table at the close. Since our virtual portfolios were very well hedged, there was no need to take upside insurance, a comeback in our long positions after wiping out our callers will be reward enough for next week while a continued decline will mean huge gains on our remaining index puts and I reiterated my EOD position at 3:46: "Markets go up as well as down, selling into the initial excitement today is a good plan for DIA and QQQQ puts but, as I said earlier, due to the never-ending series of mattress positions, I have a ton and a half and I will be super well covered by selling 1/2 (cash always makes a nice blanket!)."

That left us on the day with:

400 Nov $142 puts at $7.25 (up $36,000) hedged with 400 Nov $135 puts at $2.75 ($110,000). Since the $135s are at 100% premium and the premium on the $142 puts is just .15, this position can withstand a 200 point gap up on Monday and will make an additional 38% if the market stays flat to down through Nov 16th. Of course, there are likely to be adjustments!

0 Nov $140 puts, cashed out at $4.50 for $67,000 for a profit of $31,500.

300 Nov $137 puts at $3.80, basis $2.61. Since I sold half for $3.60, that brings the basis down to $1.62 on the remaining calls. That will be the number I place future decisions on, including setting a stop at $3.30 to protect a double.

0 Nov $135 puts, cashed out at $2.75 for a $22,500 profit (up 37%). I couldn’t hold these and hedge my $142 puts with the same position.

150 Nov $134 puts at $2.50, basis $1.77. I never got a chance to fill these as I was cheap and missed a nice gain there from 2:30 as I was trying to get $1.75 for too long. That was a bad move as it is normal to lose money on the last leg of a mattress play so it was pure greed that stopped me from doing better.

While the gains are nice, it’s important to realize that what we did is funnel (example) 30% of our profits into contrary plays as the market went up. This enabled us to make non-panic exits near the top as we’ve had 2 week’s worth of dips and recoveries prior to the big drop this week. The gains are a bonus but, to the extent that we recovered our principal while not losing more than 30% of the maximum gains on our long positions (and following the normal 20% rule should have kept you out of trouble there!) then our gains will have EXCEEDED the 100% maximum possible gains for an unhedged position!