Hedging Options with Options—More Reward,Less Risk

If we enter an option trade instead of an asset trade, whether by buying options or writing them, hedging becomes more useful. We can again apply a hedge when we enter an option trade if we wish, and we have remarkable flexibility in how we may employ this tactic. If we believe that May silver will rise and its price is now at $4.30/oz., we might consider buying May silver 4.25-strike calls, or perhaps the 4.50 calls.

We can, of course, just buy these options and hope the market moves in our favor, but we are not statistical favorites to profit if we do, other things being, again, equal. If we hedge the trade when we enter it, possibly by writing the same number of 4.50- or 4.75-strike calls, we create an option spread, in this case what is usually called a bullish call spread.As we prefer to do, we’ve eliminated the contest risk in the trade by writing the options,but we’re still dependent on the market moving in our desired direction, in this case higher, if we want to claim a profit.

The truly pleasant thing about applying a hedge to an option trade is that, unlike in an asset trade, we can still do so usefully after the market has moved somewhat higher or lower. Suppose it’s July 24 and we’ve just bought a March Chicago wheat 3.40-strike call, with March wheat (ticker symbolWH) now trading at $3.37/bushel. We paid 23 cents for this option, and it will expire next February 21. Suppose now the case that WH moves up to $3.60 by October 1.

Our call will have moved up rather nicely, to roughly 351⁄4 cents, and we’re sitting on about 115⁄8 cents profit net of costs.We can take our profit right now if we wish, or we can sit still and enhance the profit if the market will oblige by continuing higher. We have a third choice, though. We can retain chances for enhancing our profit and simultaneously reduce our capital risk, in the case of WH moving back lower,by writing a different strike December or March wheat call against our now profitable position.

December wheat is probably trading around $3.56 when March is at 3.60, and the December 3.50 call is probably trading for 18–19 cents. If we write this call and net 18 cents for doing so, we will have established a position that will be profitable from approximately $3.40/bushel to infinity between now and the expiration of the December options on November 22. In short, we’ve insured against the wheat market giving up the bulk of its gains, and we’ll make a few more cents if wheat proceeds higher or stays right here until Thanksgiving Day.

If we were more bullish but still wanted to exercise some caution and protect part of our gain, we might alternately write the December 3.70 call at this point.If WH instead moves lower, let’s say down to $3.20 by October 1, the 3.40-strike call we bought is now only worth perhaps 131⁄ 2 cents. We can accept the loss, or we can sit and hope that wheat turns back around and moves higher, or, again, we can take action.

The December 3.40-strike calls are now trading at 8 cents. We could write one of these calls and reduce our current loss without adding any trading risk, but we will curtail our profit potential unless we are very lucky with timing and market movement. We could write two or even more of the December 3.50-strike calls, now trading at 51⁄4 cents, and eliminate our loss entirely (for the time being), if we decide that Decem-ber wheat will not move well above $3.50 before its options expire.

This latter tactic embodies some risk, definitely, because various events might propel the price of wheat way over $3.50.The point here is entirely that, when trading options rather than assets,we have more useful tactics available to lay off some or all of our risk, or to reduce or erase our open loss in a position, and risk reduction is the goal toward which we always must work.

Unlike establishing a hedge against a losing position in an asset, the fact that we initially chose an option position removes one major disadvantage. We no longer have to worry about the possibility of choosing between a continuing adverse move in prices or morphing our position into a new one that is the effective opposite of our original market view. All we can possibly lose from here is the remaining value of the initial option purchase less the amount we pocket by applying the hedge. The trade may even return to profitability at some point, but we certainly won’t be counting on such a result.