Kirk Du Plessis 15 Comments. With a credit spread, you are betting that the position will expire worthlessly and thus are effectively taking a short position in volatility. As such, decreasing Vega will be profitable while the opposite will be harmful to your position.
So what do you do? This will now create a position similar to the one below. When companies announce earnings each quarter we get a one-time volatility crush.
And while most traders try to profit from a big move in either direction, you'll learn why selling options short-term is the best way to go. Click here to view all 10 lessons? You can choose to purchase an in-the-money option that has the same expiration month as the contracts of your spread and one-half as many options as are on each leg of your spread.
Ultimately, this will result in the effective delta of the selected hedging option equaling approximately 1. To trigger this hedging option, all that is needed is for you to set up a contingent order with an underlying price close to the stop loss on the credit spread. Once the underlying instrument reaches support or resistance, you can take away the profits made on the hedge option position and still keep the hedge spread. If you are lucky, this credit spread could expire worthless leaving you with a full premium to collect.
This way, you will be able to make profits on two fronts; the credit spread trade as well as the hedge position. However, if you are risk-averse or just want to take precautions, you could opt to exit your credit spread and only take the profit from the hedge position. Another great method you can use to hedge your credit spread involves purchasing an in-the-money option that has the same expiration as your credit and a delta equal to two or three times that of the net delta of the position.
You can then initiate the hedge at the same time and manner similar to the approach explained above. However, your target this time will be to make profit on the hedge position alone.
Thereafter, you can decide whether to unwind your spread or just retain it till expiration especially if it reverses back towards the initial target. In both approaches, you can choose to buy back the short options with an aim to create a vertical credit spread especially if the spread still has a lot of time value left and that the underlying is reversing steadily in the direction to which it was initially targeted.
If you are planning on buying protection or hedging an options position, what are the things you look for? In other words, what are your criteria before making the trade? Add your comments below and share your insight. Kirk founded Option Alpha in early and currently serves as the Head Trader. Kirk currently lives in Pennsylvania USA with his beautiful wife and two daughters. However, what happens if the stock does close in between 40 and 45 at the end of the cycle, could you be forced to buy the stock at 45 and the other just expires worthless?
I am a bit confused here. Or just roll out to collect the higher volatility premium for farther out expiration or could even roll out and down if volatility went high enough to still get credit for rolling at lower already. Not quite following this. Correct you want the options to expire worthless. Should the market turn higher sell back the insurance. This strategy can be an option for hedge. With this we cut losses and can profit avoiding extra commissions? Not sure I follow you completely Manu.
The idea here to is hedge very very cheap with a deep OTM option long. Sorry, I just read my comment it was not very clear. I was thinking that instead of buying a third put contract. If that is even possible i dont know , whould it be better? Since we will only pay 3 commissions and the effect will be the same. Thank uou for the reply Kirk, I love option alpha.
Yeah you could do that but you would only want to leave the long option open if the current value is very very cheap like 0. Glad you love OA — please us with your social circle: Yes true so check with your broker to see if they will automatically exercise the option or not.
A hedged position is seldom a no-loss position, but rather, it is a move to define loss and avoid a catastrophe. There is always risk in any position that anticipates a gain, including the hedge itself. Hedges are used to mitigate a loss, often with the possibility of it turning into a gain, in certain conditions — here it would be if the share price would run down through all strikes.
This will help me visualize much better. Another way would be to sell a corresponding call credit spread of 10 contracts. This would basically give you an iron condor. Hedge Fund of One. Free Video Training Courses.
Daily Options Trading Alerts.More...