Vacation-Proofing Your Virtual Portfolio

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 4^th 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!

Strategy

*** Note, these are examples of hedges, NOT recommended trades for this week.  ***

Long Call > Straddle/Strangle

• A long call can easily be converted to a straddle or strangle by simply adding a long put option at either the same or a different strike price respectively.  A similar expiration date is used for the long put (otherwise it would be a calendar straddle/strangle)
  • ABX Oct $40 calls at $4.90 could be protected with October $38 puts for $1.20.

Long Call > Call Calendar /  Bull Call Calendar / Bear Call Calendar

• A short call placed at the same strike price as a long call converts a directional long call into a spread trade called a call calendar.  If the short call strike is above the long call strike the trade is a calendar bull call while if the short call strike is below the long call strike, the trade is a calendar bear call.
  • Sept. $16 TIE calls at $1.95 can be offset by selling the Aug $18s for $1

Long Put > Straddle/Strangle

• A long put can easily be converted to a straddle or strangle by adding a long call option at either the same or a different strike price respectively.  A similar expiration date is used for the long call (otherwise it would be a calendar straddle/strangle)
  • Aug $80 GMCR puts at $5.65 can be neutralized with Aug $85 calls for $6.

Long Put > Put Calendar /  Bull Put Calendar / Bear Put Calendar

• A short put placed at the same strike price as a long put converts a directional long put into a spread trade called a put calendar.  If the short put strike is above the long put strike the trade is a calendar bull put while if the short put strike is below the long put strike, the trade is a calendar bear put.
  • Aug $460 PCLN puts at $20 can be offset by selling the July $475 puts for $11 if our worry is that it climbs even higher.

Bear Put (Long put with a short put at a lower strike) > Put Calendar / Bull Put

• A bear put takes advantage of bearish trends.  Should new information arise that changes your outlook, you could certainly consider rolling the short put up to the same strike price as the long put though a shorter timeframe, thereby creating a put calendar.  A bull put could also be created by simply rolling the short put up in strike to a price higher than the existing long put strike (same expiration month).
  • We have GLD Jan $140 puts at $6 for protection (now $5), we see the gold bounce off the $1,500 line and Ron Paul conducting investigations into Fort Knox just as we're about to leave for 2 weeks.  Rather than take a loss selling them today we sell the Jan $142 puts against them for $6, taking advantage of the momentum that flows against us.

Bull Call (Long call with a short call at a higher strike) > Call Calendar / Bear Call

• A bull call makes money in bullish trends.  In the event that the expected bullish move does not materialize, you could roll the short call down in strike price to the current month while maintaining the existing long call position, thereby creating a call calendar.  A bear call may be an appropriate conversion if the move is bearish as opposed to stagnant.
  • MCD Nov $62.50s at $4.35 can be offset with the sale of Nov $65s for $2.55 if worry it is stagnating and eating into your premium.

Bull Put (Short put with a long put at a lower strike) > Ratio Put Backspread / Collar Trade

• Bull puts make money in flat and bullish trends.  In the event that a stock breaks aggressively bearish on some unexpected news, additional long puts can be added that results in a trade that has more long options than short options (i.e. a ratio put backspread).  Also assignment of the short put could be taken with resulting stock ownership arising.  Should you end up taking ownership of the stock, you could simply add a long put and short call to convert the trade into a collar trade.
  • DIS July $38s at .60 can be saved by selling the July $37s for $1.19 if their latest film is a flop.

     

Bear Call (Short Call with a long call at a higher strike) > Ratio Call Backspread / Synthetic Strangle

• A bear call takes advantage of flat and bearish moves.  Should a stock move bullish above the short call strike, an additional long call can be added to form a ratio call backspread.  On the other hand, if you happened to be assigned early and end up with a short stock position, you could simply roll the long call from the bear call further out in time and created a synthetic long put.  If you now add another long call you effectively end up with a synthetic long put and a long call or a synthetic straddle/strangle.
  • If we become concerned that 10 GOOG Sept $500s at $13.50 ($13,500) may be in jeopardy, we can sell 7 July $480s for $12.20 ($8,540).  Google would have to finish the month at $492.20 just for us to give our caller his money back while all 10 of our calls will experience $18 worth of stock appreciation, less time decay (perhaps +$4). 

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 4^th of July!

Option Sage