Here’s A Quick Way To Hedge Credit Spread Option Strategies

With the recent volatility a lot of traders are asking about quick ways to hedge their current credit spread option strategies. As with all hedge positions or adjustments you make, you have to consider the price or premium it costs versus the insurance you are getting. It’s just like buying insurance on your house; you want the lowest premium with the highest coverage.

Protecting Against Vega Spikes

Specifically I’m going to discuss hedging a put credit spread since that seems to be where most traders lose their shirts trading – i.e. when markets are falling hard and they aren’t protected. As stocks fall, volatility typically increases, both increasing margin requirements and also swelling your credit spread premium.

It’s this volatility or Vega that we really want to hedge against. With a credit spread you are betting that the position will expire worthless and thus you are effectively taking a short position in volatility. Decreasing vega will be profitable while increasing vega will be harmful to your position.

Starting With The Base Chart

Here is a profit/loss (P/L) chart that shows what a typically put credit spread looks like at expiration. For this example, lets assume you sold 1 $45 strike put and bought 1 $40 strike put for a net credit of $200.

Notice that if the stock trades any lower than than $43 (your break-even point) you will start to lose the $200 premium you took in on the initial trade. After $42 you are out the entire premium. Clearly you have limited downside risk but you still could be over-exposed to a big market sell-off right?

Leg Into A Put Back-Spread

A quick and relatively easy way to hedge this position would be to purchase another OTM put option at/or lower than the $40 strike price. This will now create a position similar to the one below.

This is a “hedge” and not intended to eliminate the potential for losses but it will protect from further increases in volatility and reduce your overall margin requirements. Now, a huge downside move in the stock will be hedged below $40 and you would actually start to make money if the stock really continues to fall apart.

You still keep a heathly premium on the overall position (assuming the hedge wasn’t too expensive) and protect from a major market move lower. What more could you ask for in an option hedge right.

What Do You Look For In A Hedge?

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.

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