One of the most common questions I get asked by traders here is, “How can I hedge my current credit spread option strategy?” In most cases, my answer to them is usually very simple- 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’ll want what has 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, increasing margin requirements and also swelling your credit spread's premium.
It is this volatility, or Vega, that we really want to hedge against. With a credit spread, you are hoping that the position will expire worthless, and thus are effectively taking a short position in volatility. Thus, decreasing Vega will be profitable.
Starting with the Base Chart
Here is a payoff diagram for a put credit spread at expiration. For this example, let’s assume you sold a $50 strike put and bought a $45 strike put for a net credit of $100.
Notice that if the stock trades any lower than $49 (your break-even point) you will start to lose the $100 premium you took in on the initial trade. Below $48, 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. So what do you do?
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 $45 strike price. This will now create a position similar to the one below.
This is a “hedge and thus it’s not intended to eliminate the potential for losses. However, it can help protect from further increases in volatility and reduce your overall margin requirements. Now, a huge downside move in the stock will be hedged below $45, and you would actually start to make money if the stock really continues to fall apart.
Besides, you still keep a healthy premium on the overall position (assuming the hedge wasn’t too expensive) and protect from a major market move lower.
Other Techniques You Can Use to Hedge Your Credit Spread Option Strategy
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 1.3 times that of the net delta of your spread.
To initiate this hedge, all you need to do is 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.