Q&A
Explore Your Options
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C.
SHORT STRADDLE TO HEDGE?
What’s your opinion on establishing a short straddle hedge to offset the risk of a long straddle?
If a trader wants to establish offsetting straddle positions in different contract months, the combined spreads can be an effective means of reducing the risks associated with the greeks of theta and vega. The net position is commonly referred to as a double diagonal.
A long double diagonal can be approached when a trader wants to hold long curvature or premium in a longer-dated straddle in anticipation of a stock move and/or increase in implied volatility but is concerned that a quiet near-term underlying instrument will pressure the spread.
If the trader’s technical assessment is correct, by selling a closer-in straddle that decays faster due to its higher theta factor, he or she will benefit. In this situation, the double diagonal should expand in value due to the near-term short straddle collapsing faster than the held longer-term spread.
At that point in time, the double diagonal could be closed for a profit. The trader could also roll the short out for a month if the time between the two spreads allows for the adjustment and the trader maintains the same view at that point in time.
A separate offsetting straddle hedge is when a long and short straddle is established in the same calendar month. Like the double diagonal, a short straddle maintained on a different strike can reduce decay and volatility risk. The caveat in constructing this position: the trader is now holding the equivalent of either two bull or two bear vertical spreads.
When the long straddle is established on the lower strike relative to the short straddle, two bull vertical spreads is the net position. Conversely, when the lower strike is home to the short straddle, the trader is committing to the risks and rewards associated with a bear vertical strategy. In each instance, the delta component plays a more significant role in profitability than with the double diagonal.
SPEAKING OF VERTICALS
I’ve heard verticals discussed as being both a good way to reduce vega risk as well as not being a practical means to that end. How can both be right?
Actually, both answers are correct. The effectiveness of how a vertical can reduce vega or theta is going to be largely determined by the distance between strikes, implied volatility, and time remaining to expiration.
For instance, a situation where a bull call vertical would do a good job of reducing theta and vega risk would be if the position was established on a stock with high implied volatility on adjacent strikes and a couple weeks left until expiration. One recent example would be Research In Motion (Rimm).
Back in late September and in front of its earnings release, Rimm shares were trading near $83. At the time, the at-the-money October 80/85 call spread fetched $2.50. By selling the 85 contract for $4.30 (closing price September 24) versus simply holding long the 80 call for $6.85, the trader’s vega would be reduced from risk of $0.077 per point drop in implieds to a slightly short/flat factor of -$0.004.
Similarly, decay or theta risk of more than -$0.11 and growing daily on the outright October 80 call would be flipped into a marginally positive factor with this particular vertical spread.
Traders should be able to appreciate the short call’s impact on theta as Rimm needed only to sit at $83 to realize a profit of $0.50 per spread as the vertical expanded into expiration. That’s related to the 100% extrinsic value of the 85 call, which is larger than the extrinsic component of the 80 call.
The reality of this particular vertical turned out quite different as Rimm shares plunged following its report. Nonetheless, for the outright bull holding only the long call, the experience was much more painful due to the greeks associated with that contract.
VERTICALLY CHALLENGED?
I’ve been thinking of selling puts on companies that I believe have strong long-term prospects. If I get assigned, I’m able to buy the stock at a discount to where I see it as attractively priced. If shares remain above the strike, the premium is collected and I can look to reestablish an additional put sale if my outlook remains bullish.
I know selling naked puts receive lots of bad press and is viewed as a risky strategy. But would this approach really be a poor one if I’ve “done the homework” like Cnbc’s Mad Money host James Cramer emphasizes so often?
Selling a naked put on a risk basis is the same as establishing the buy-write, which most often is preached as a conservative strategy. Semantics aside, my belief is that a bull put spread is a stronger approach. By selling a bull put spread as opposed to the naked put sale, the discount purchase you crave in shares is much more manageable in the advent your outlook changes as the stock price drops in value.
With the put spread, if you’re eventually assigned on stock but no longer harbor the same optimistic prospects for the company, you have a definite out. While the trader obviously gives up some premium collection due to the purchased put, there’s much less stress with regards to your obligation to buy shares as market conditions shift and, quite likely, one’s perception of underlying value.
Whether the designed spread involves a purchased put 2.5 points, five, 10, or even 20 points below the sold strike, a trader has absolute control over their maximum loss. That’s something to consider versus the sometimes-riskier alternative of having to use the open market to dump any acquired shares at possibly much lower prices that fall well below what was previously viewed as a “discount.”
Contributing analysis by senior Optionetics strategist Chris Tyler.