Market Measures

Tactical Hedging

| Feb 20, 2015
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    Market Measures

    Tactical Hedging

    Feb 20, 2015

    One of the most successful strategies that we can employ when trading options is selling short puts. This has been highly successful due to the positive drift in the market. This is allows us to collect premium for a lower cost basis than just buying the market outright so that we are able to produce a better return on capital than just buying and holding a major market index.

    Additionally, we can also bring in additional premium by selling a call against the put in order to hedge ourselves more from the downside risk. We have found this is a very effective strategy, and typically it works better than not doing it. This can be shown in the Market Measure episode Calling All Puts. However, when we sell a call against a put, we now have upside risk. Is there any way that we can reduce this risk?

    Today, Tom Sosnoff and Tony Battista look at a different way that they can hedge a short put. If an individual underlying as taken a large down move, it would make sense to sell a put if you believe the underlying will recover. However, instead of selling a call in the underlying as well, the guys look sell a call in the exchange traded fund (ETF) of the index that the underlying belongs to. For example, if WMT was down and we looked to sell a put to play for a reversion, we would look to sell a call in DIA.

    Since we are using the general market index to hedge a short put, we’re reducing some of our downside risk but not capping our upside in the individual equity. Instead, we now have upside risk in the broad market. This is beneficial because the overall market will move slower than and individual equity. Additionally, we can typically move further away from the money when using options on an index than you can when you are looking at an individual equity.

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