How to Hedge a Call Credit Spread

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Call credit spread: In this video, we're going to go over just the two quick trades that we had today on Wednesday, December 2nd. The first trade that went through is an adjusting trade on Alibaba which is BABA, and I wanted to go over instead, our quick closing trade first on XOP.

We've got a lot of different positions in oil and gas and have had some, over the last month or so, and really, we've got trades on both sides of the markets. We're long on a couple of things; we're short a couple of things. 

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In this particular case with XOP, this was a bearish position we put on a credit call spread where we sold the 39 calls, bought the 41's originally. We're now reversing out of that trade at our automatic exiting price of 25 cents per contract and took in a nice profit of about $120 on that trade today.

Implied volatility's dropped just a little bit since where we entered the original position but mainly what we saw is just a little bit of time decay work in our favor and that nice drop down in the stock price today because XOP actually trade down about 4 1/2%, really helped solidify this thing and turn it into a really nice, quick winner.

Again, this is what we're trying to do. We've got positions on both sides of the market. We wanted to be able to take off things when it's advantageous to us whenever the market moves in our direction.

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The other trade that we went into today or adjusted is the Alibaba trade. I want to go over the adjustment here, and then we'll walk through the thought process behind that, but the actual adjusting order is two new contracts, it's a new credit spread that we added. We added the corresponding put credit spread below the market 82 1/2 put strike.

That's the same short strike that we have on the call spread side with our original call credit spread, and then we bought the 80 puts again. Keeping that same width of the number of the contracts, the 2 1/2 dollars and the same quantity of trades, that way it's all risk neutral meaning that we're not adding risk to the position by doing this adjustment, we are 100% reducing risk in this position by making an adjustment like this.

We reduce risk by the credit that we receive, so about 45 cents for each contract, so about $90 overall right now until we do anything else. This is what's happened here with BABA. We've had originally the call credit spread that was above the market. The stock is seeing implied volatility drop.

That has worked out in our favor, but the stock has moved 100% against us. Now, we've got some time between now and expiration, so you don't necessarily do this adjustment if you want to, but in our case it kind of works well into our overall portfolio because we need some more bullish trades.

This is a bullish type of adjustment because we're adding a put spread below the market. This is a look at where our credit spread is before the adjustment. You can see this is our payoff diagram at expiration, no adjustment right now and Alibaba is trading right here at this dotted line in the middle of the screen at 85 08, so what we're doing here is we're trying to do two things.

One, we just want to reduce the risk of the big continued move higher. At this point, we're down about $200 but if everything stays right here we'd be down about $400 on this trade, and if Alibaba continues to move higher, obviously that doesn't bode well for our position. What we want to do is we wanted to add the corresponding put spread right below the market.

All we're doing is we're selling the same short strike here at 82 1/2, and then we're buying the 80's, and now you can see we create this very nice, very even iron butterfly right over the market. Again, the whole idea here is that we're reducing risk on this side of the market. Yes, we do sacrifice a little bit of potential probability of success now with this trade because we have a smaller window that the stock can land in, but don't be fooled by the major goal of doing an adjustment.

Making an adjustment to trade is mainly to reduce risk and stop the bleeding. You've got to save the patient on the table by stopping the bleeding before you can ever hope to turn things around and bring them back to life. That's what we want to do with trades.

If a trade goes against us, we need to first stop the bleeding, reduce risk, don't add risk, reduce our overall potential risk and then still leave an opportunity to make some money. Right now, we've left ourselves an opportunity to make some money. The stock can drop 85 all the way down to about 81 1/4 or so.

We still have some opportunity to make money inside that range, and with expiration coming closer and closer and closer, that opportunity's going to be more and more prevalent. Right now we just wanted to first reduce the risk on the trade, and that's what we did today by adding that corresponding put spread.

You can see in the simulated trades here, which has our positions, all we did is add that corresponding put spread. We did the same short strike as our original call credit spread and just made sure that we did everything right around 82 1/2. This way we don't go inverted by any means, and we try to take in the biggest possible credit that we can take in right now with this particular trade.

As always hope you guys enjoy these videos. If you have any comments or questions, please ask them right below. If you're watching this video somewhere else out there online or on youtube, you just have to understand that these trades and all of these alerts that go out to our members are sent out the same day, but this video only gets posted publicly about 20 to 30 days after it's sent out to our members.

If you want real-time alerts and real-time trades like the one you see tonight in this video, you have to go to optionalpha.com and sign up for membership. Until next time, happy trading.

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.