OAP 055: Hedging Strategies – Balancing Your Stock or Options Portfolio

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Market neutral, delta neutral, or balanced portfolio; call it what you want but the concept of making money regardless of where the stock market goes has been a long-time goal for many traders. But what happens when your portfolio becomes unbalanced? What are the best hedging strategies you can use to get back to a neutral stance?

In today’s show, I'll walk through three different portfolio scenarios and offer my advice on the best hedging strategies to use to help re-balance your positions. You'll hear which options strategies to use if you're too bullish, too bearish or completely lopsided. Plus, I'll help you learn how to hedge stocks that don't have tradable option contracts.

Of course, it all starts with a solid understanding of how to determine what your portfolio looks like on either a beta-weighted or delta-weighted basis. It's enough anymore to just have a couple of bearish trades and a couple of bullish trades. You have to determine what the net impact of each position is in the overall portfolio. If you can do that, you'll be well on your way to consistently generating income with options regardless of the market direction.

And as always, if you've got questions on portfolio management or hedging trades, add them in the comments section below, and I'll make sure to reply personally to every single one.

Key Points from Today's Show:

  • A hedge is a counter trade to something else that you are doing. Meaning, if you are trading something long, then a hedge is trading something short.
  • A hedge is not meant to always be a one-to-one relationship. It is just the idea that you should be having multiple positions in multiple directions at one time - some bullish, bearish, and neutral positions in your portfolio.
  • Have to have an understanding of what your full portfolio looks like on a beta-weighted or delta-weighted basis. Most broker platforms have an overall evaluation method for this.
  • Think or Swim list two ways of determining what the beta or delta-weighting of your portfolio is. This is important because you have to look at it on a apples to apple basis.
  • As a rule of thumb, use one ETF or benchmark for your entire portfolio - S&P 500. This allows you to have a good frame of reference for how you should adjust or add trades going forward in the future.
  • Once you find out where you portfolio is and how it is balanced, you have to figure out if you are lopsided in one direction or another, or on both sides. The goal is always to be as neutral as possible, meaning to have a nice even distribution or normal distribution graph kind of centered over the market.
  • Want to avoid the one-directional risk of a single position. This is why you want to add hedging strategies and different trades at all times in your portfolio - don't want all your eggs in one basket.
  • The more trades and positions you have on, the less risk you have in your overall account.
  • Can use any security to hedge another security, as long as you know how that security reacts to the market. If you can match up two securities, then you can have a well-diversified portfolio.
  • Can default to the most liquid security out there with the highest implied volatility because you can factor in the Beta equivalent of that position.

Two Ways to Determine Portfolio Balance

1. Monitor tab, under activities and positions.

  • The website does the calculation and shows you what your relative risk is to the market moving up.
  • Now you can look at one benchmark, one index, and build everything around that benchmark/index, no matter position or industry you are trading — the goals is to have your delta in a neutral range.

2. Risk profile and analyze tab.

  • Type in symbol and analyze position based on a single symbol or portfolio beta weighted basis.
  • When Beta weighted to SPY, now your entire portfolio is going to show where you make money based on where the movement of SPY is.

Hedging Scenarios:

1. Portfolio is Too Bullish:

  • Here you will make the most amount of money possible if the market moves ups in direction, so you should add some bearish positions to your portfolio to help counterbalance the fact that you are already bullish.
    Examples: put calendar spreads, call credit spreads, or put diagonal spreads.
  • Put calendar spreads and put diagonal spreads allows you to profit from market rise in volatility — when market goes down.
  • However, if the market is experiencing high volatility and you need to be more bearish, sell call credit spreads that are out of the money and above where the stock or ETF is trading.

2. Portfolio Too Bearish:

  • For this scenario, trade naked short puts or short put credit spreads below the market. These are the best strategies to use when you want to gain some bullish exposure and sell high overpriced option premium and volatility.
  • Use long call debit spreads, when the market is experiencing low volatility and your portfolio needs some bullish exposure. Best strategy if you need some bullish exposure, regardless of volatility.

3. Portfolio is Too lopsided:

  • This scenario rings true when your portfolio has good exposure in the extremes, but nothing in the middle, nothing that profits from the market staying in a range or a defined area.
  • You will need to get more neutral with straddles and strangles, iron butterflies, and if there is low volatility you could do some at the money calendar spreads in one direction or another.
  • This will help raise the middle curve of your portfolio and allow you to profit from the market staying range-bound.

4. Long stock and getting started:

  • A quick way to hedge is by using a cost-less collar (Episode 30). This is a zero-cost way to protect your portfolio from a slight drop in stock price
  • Entails buying an at the money put spread and then selling a call to finance that trade for a net credit. It costs no money and reduces your risk in the trade by the credit you receive.

5. No or lightly traded options:

  • Not all stocks are optionable, or have liquid options that you'd want to trade. When hedging, you want to go to a related beta or industry or company security in that sector/market.
  • Example: if trading Facebook, use Twitter as a relatable stock to hedge that position. If trading Chipotle, use McDonalds to hedge.

Another Hedging Example:

You are trading Microsoft and you don't or can't get into trading another hedge in Microsoft, so you've got to use something else. Microsoft has a Beta of 1 so it will mimic what the S&P 500 will do, more often than not. Can then type in anything — TLT, which has a -0.52 correlation to the market. This means that if you got short TLT by a factor of 2, then you have a -1 hedged and matched up Beta to the Microsoft +1 beta position. Therefore you can use anything in your portfolio to hedge anything else. It's just a matter of finding the most liquid securities.

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Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn't just for professional traders; it's for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • IWM Iron Butterfly (Closing Trade): Exiting this IWM iron butterfly options trade gave us a $1,100+ profit after pinning the stock price one day before expiration at the peak of our spread.
  • CMG Iron Condor (Opening Trade): I just recorded my live trading platform (and real money account) as I walked through the process of entering a new iron condor trade in CMG stock. Inside you'll see me analyze, price and fill the trade in real-time.
  • APC Strangle (Closing Trade): Took about $150 out of this small APC strangle trade even after the stock moved completely against our short call strikes this month. But as always, implied volatility always trumps direction and because IV went down, the value of this spread dropped more-so than the impact of the directional move higher.
  • IYR Call Credit Spread (Adjusting Trade): This adjustment is good for 2 reasons. First, it reduces the overall risk in the trade if IYR continues to move higher. Second, it still leaves room for the stock to fall back down into our new profit window.
  • XHB Straddle (Closing Trade): We were able to bank a $120 profit early in the March expiration cycle for our XHB straddle with the stock trading right in the middle of our expected range.
  • AAPL Call Calendar (Opening Trade): Look behind the scenes as I use our new watchlist software to filter quickly and find this AAPL call calendar spread trade during overall low implied volatility in the market.
  • COF Strangle (Adjusting Trade): Here I recorded my live trading screen (and real money account) showing you the entire thought process we used to make an adjustment to my current short strangle in COF to reduce risk.
  • GDX Strangle (Opening Trade): With gold's high IV we are getting into a new strangle with a 70% chance of success and a decent credit for selling option premium.
  • IBB Iron Condor (Closing Trade): Today we're exiting an iron condor we traded in IBB for a $142 profit. Inside you'll see me analyze the exit price and fill the trade in real-time.

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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.