Hedging and Adjusting Oil Option Positions Correctly

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Hedging options: Tonight, we’re going to go over all of the trades that we’ve made for December 1st. I can’t believe it’s already the last month of the year, but hopefully, you guys had a lovely holiday. I know I emailed back and forth with a bunch of people over the holidays, but hopefully, everything was good, and it was good to enjoy both times off work and then also time with family, always necessary.

Today, we had a pretty active day with adjustments, cleaning up a lot of stuff as it relates to oil because of the massive move lower that it had on Friday of last week. Friday was a short trading day, but just because it was a short trading day, it was not absent from activity especially in the oil markets with the announcement from OPEC on supplies and oil just took a nosedive.

We’ve spent the better part of today just cleaning up positions, taking some profits on some positions and readjusting others to make sure that we’re covered in case oil does go lower. That's what the bulk of tonight's video is going to be on, is how we went about going through and adjusting some of these positions. Now, if you’re a part of the premium membership, we talked through a lot of this stuff that we already did today last night on the strategy call that we do on Sunday evening.

If you want a little bit of an inside edge on what we’re doing ahead of what the alerts come out with, you’ve got to sign up for a premium membership because we did talk about a lot of this stuff last night with the call with those premium members.

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The first one that we’re going to go over today is just really quickly the closing trade that we had in COP. COP is ConocoPhillips, and we had originally sold the December 72.5/75 call spread and sold that with the intention that this is a hedge. You can go back to the video tutorial that we did that day that we entered that order. This was intentionally doing a call spread against our positions in oil because we wanted some hedge as oil possibly went lower.

Well, as oil did jump less, ConocoPhillips gapped lower and naturally, the 72.5/75 call spread became almost worthless. We bought it back today for a $.10 debit. It was too much risk left on the table. It did exactly what we needed it to do, so there's no use in letting it go for another $30 before commissions. We took a nice little profit on that hedge just to help out in the other oil positions.

When you see ConocoPhillips, you can see this is the story with a lot of oil stocks that had a huge move lower on Friday last week, and most of them regained their balance today. And I don't know if this means that we’re going to continue higher or if it’s just more sideways action, but a lot of them that were down early, XOP, USO, PVR, etcetera, a lot of these stocks actually had a really nice run into the close which is really boating well for possibly some little bit of market reversion or stabilization, whatever the case is. In the case of COP, we did decide to go ahead and take profits on that side of the trade.

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Then with other trades that we made, we started getting into some of the adjustment trades that we did. The first one that we did today is the RIG adjustment. This is one that we talked about with members on the call last night. RIG is another oil-related stock, so what we decided to do is go into something a little bit different, get away from USO, XOP, etcetera, and just go into something that's related to oil that we can replace our COP trade that worked in our favor. We want to do the same basic thing with COP, but just doing it with RIG.

Now, in this case, we did a little bit different because it's a $2 wide strike versus a $2.5 wide strike, we had to sell just another contract versus the three that we bought back on COP. You can see it’s very systematic, the way that we’re going about this. We’re not trying to just whimsically throw trades out there. We’re very methodical about how we’re making adjustments.

And this RIG trade is a replacement type of trade to COP that we just closed out and that's why it was a little bit higher in contracts because the spreads were a little bit narrower, so we had to take in more of that spread. Now, we also talked a lot about Deltas last night, and I don’t want to get too much into that in today's video tutorial, but those premium members who were on that, we talked a lot, probably about 15 to 20 minutes just on neutralizing Deltas and being Delta neutral with your trading.

For RIG, we did sell the 20/22 call spread, and we did that for an $.84 credit, so a pretty hefty credit. And the whole idea here with RIG is that we wanted to take advantage of possibly a continued move lower in oil. And if oil does continue to move lower, we need some hedge above the market to counteract the positions that we have right now.

You can see that RIG has almost 100% implied volatility right now, so it’s an excellent candidate because it’s an oil sector and it’s got high implied volatility, so we’re just going to play it to the downside. Thankfully actually, RIG was one of the ones that continued to move lower today whereas USO and XOP rallied off the bottom, so it’s fascinating to hedge. It worked out a little bit better in our favor.

And then the another adjustment that we’ve made and then we’ll get to X is in XOP. XOP via a vertical call spread, we decided to roll down our 55 calls to 49. Don't get too confused on the actual order. We just entered a vertical spread order. But remember, a vertical spread is selling that front contract with a 49, buying the 55 contract or the back contract. But we were already short the 55, so when we bought it, we bought back our short 55 call which is worthless at this point.

It’s serving us no purpose at all. What we did is we rolled down to the 49 call. That combination took in an additional $1.90 in credit which helped move our breakevens out just a little bit further. Here's what XOP looks like and we’ll go through this here on the chart. But our 55 was right here; our 55 calls were right about here, and you can see as XOP moved lower, then what we did is we decided to roll down to 49.

We rolled these calls that we have here at 55; we rolled them closer to the market to rebalance the position and re-center it as much as we could over the market. Now, it had a nice little rally off of the base today, and that’s okay, that’s what we wanted after we made this adjustment. If we go here to the analyze tab, you can see that our new position in XOP looks like this. And this doesn’t take into account any other adjustments that we’ve made previous to this, it’s just the two trades that we have right now which we are short, the inverted strangle, the 67 put, and the 49 calls.

The 67 put is all the way over here, and the 49 call is all the way over here. Ideally, all we want is we want XOP to trade somewhere between that range between now and expiration. You can see it rallied up just a little bit today, so this was good, this re-centered our trade. If we can get XOP to continue to trade somewhere in that range, then we should be good to go until expiration. We’ll see what happens and we’ll obviously make adjustments along the way.

The last two trades that we made, and we made a very similar type trade as XOP here; we just did them in two separate orders primarily with X which is US Steel. US Steel continued to move lower, with oil as well, so we did the same thing where we bought back our short 35 calls, rolled them down to and entered or sold a separate order for the 30 calls. And we just added one additional contract here just because it was filling. If filled a lot quicker with 10 contracts and we liked the credit.

We added another $2.11 for the credit on the roll down and then we have to subtract out the cost that we paid to buy back those December 35 calls. But now that these are separate, you can see exactly the logic behind rolling down that call side. As the market moved lower, all we can make is another $.38 on these December 35 calls. And we’re going off of that hypothesis for today. If X does continue to move lower, all we’re going to make is another $38 times the 9 contracts that we were short.

Well, in this case, we know that we've already made some money on those. I think we sold them for around 575 or so when we rolled them out, so we’ve made a ton of money on that particular side of the trade. What we need to do now is take in additional credit because if X does continue to move lower, then we need to factor in that additional move lower. And now, we’re going to make $211 on these particular two trades versus $38.

This is the reason why we’re rolling down, to take in more credit. Once an option has pretty much exhausted all of its money, there's no point in keeping that option on. You either close it out or roll it to a different strike price to take in more credit. And that’s the whole name of the game, is continuing to roll and extend the duration and extend your credits.

Now with X, this is what our new position looks like. This doesn't take into account anything that we did earlier in the last couple of months as far as adjustments. But if I take out this short call right here that we did, these December 10 short calls, you can see this is basically what our profit loss diagram would have looked like without those short calls. Let me just narrow this graph here down. And you can see that it’s centered now around 46, but really, the risk is dramatically lower.

If X continues to move lower which at least at this point, that’s the assumption that we’re going off of, then we are losing every single day that it moves lower. As soon as it moves to 30, we’d lose about 5 grand at expiration just on these options, not on the whole position. But on these options that are left, we’d lose about 5 grand.

By adding this short 30 calls, you can see how that re-centers, it rebalances the position whereas it used to look like this, now it’s tilted, and now it’s moved this side of the profit loss diagram down and this side up, so it re-shifted the profit loss diagram. Now, if X just stays here, then we stand to make back about $3,000 of our initial position, and we would need a move down to about 28 for us to lose 5 grand.

Instead of X moving to 30 and we lose 5 grand, now X would need to move all the way down to 28 for us to lose about 5 grand. You can see that that's why we did this and took in more credit, is we take this breakeven point that used to be 5 grand here and move it out another $2 plus, so that gives us much, much more room in the stock price and the volatility of the stock given how big of a range it’s been trading into actually stabilize the position.

Hopefully, that makes sense and probably visualizing it here on the analyze tab helps out. Those were all the trades that we made today. As always, if you guys have any comments or questions about these trades, please shoot us an email or add a comment right below this video. And 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.