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.

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. 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 two daughters.

  • guy whitney

    But even without the extra protection you mention, the max loss is still $300, yes?
    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?

    Thanks, Guy

    • Kirk

      @guy whitney, Yes correct, if the stock closes exactly at $40 – the idea again is that you are hedging the downside risk (not eliminating it).
      – To answer your other question, yes you can be assigned one leg and not the other. If this happens and you don’t want the stock (either short or long) then just exercise the other leg you have and close the position.

  • Changis

    Hi Kirk,
    In the above example shouldn’t it be a $200 net debit ? I am a bit confused here.

  • brian

    The hedge is just for gaining if stock falls apart but its not really hedging your position because the credit already has defined risk at max of$ 300 . 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

  • coptions

    Hmm. Not quite following this. If you are in a put spread, you’re waiting for the options to expire. It seems to me that if you’re going for a small credit like .30 or .40 cents, the premium for the insurance will potentially wipe out the gains from your spread, not to mention potential decay in the insurance itself.

    • Correct you want the options to expire worthless. The premium used for the hedge in this case is not intended to be held to expiration (unless the stock continues to drop at which point you’ll make more money on the long puts combined). But the idea is that you buy insurance when you need it and sell it off when you don’t. Should the market turn higher sell back the insurance.

  • Manu Murdoch

    This strategy can be an option for hedge. But wouldn´t it be better if
    we close the selling position and wait to profits with the already
    opened buying position. With this we cut losses and can profit avoiding
    extra commissions? what do you think?

    • Not sure I follow you completely Manu. The idea here to is hedge very very cheap with a deep OTM option long.

      • Manu Murdoch

        Sorry, I just read my comment it was not very clear. I was thinking that
        instead of buying a third put contract. We can close our 1 $45 strike
        put back, and only leave open the 1 $40 strike put until expiration. 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 0.05 or something). Glad you love OA – please us with your social circle :)

  • Hey Boe! Yes true so check with your broker to see if they will automatically exercise the option or not. If that’s the case then you should reverse the trade near expiration and close the strategy out.

  • Hedge Fund of One

    I like & use this hedge when I think appropriate. 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. A visible example is the huge loss sustained by the “London Whale” for $JPM – they were trying to hedge $JPM portfolio. 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. It’s ok to look at P&L as if position is held to expiration; however, a pro trader is going to evaluate position daily and close/adjust it before expiration, instead of sustaining max loss.