Hedging an Option Write—It’s a Process,Not a Single Action

The hedge can be a useful defense when purchasing assets or options, but it really comes into its own in tandem with several option-writing strategies,particularly the non-seasonal and the ratio-spread (see Chapter 11). If we’ve entered a non-seasonal trade, we have a couple of different ways to defend the trade via hedging.For a detailed example of a defense, let’s suppose the date is January 22, May unleaded gasoline (ticker symbol HUK) is 63.60 cents, each contract representing 42,000 gallons of RFG II unleaded gasoline, and the May options expire on April 25.

We’ve looked at price histories and discovered that the price of HUK has had a very reliable upward seasonal tendency from this date through the expiration of its options. We also observe that the maximum interim decline ever recorded for HUK between now and April 25 is just 14.64%. This year, with HUK trading at 63.60, that degree of decline would represent 931 points, or 9.31 cents.We’ve done our homework regarding the expectation of the trade and have satisfied ourselves that it is satisfactorily positive at this time.

We’ve also seen in our look at the behavior of this market during this period that, because of a generally warm winter throughout the United States, demand for motor gasoline has stayed atypically high so far this year. The longer-term weather forecasts, for whatever they’re worth, indicate that there is little probability of a reversion to severe winter conditions and temperatures, and, sure enough, we can’t see anything at all immediately wintry on the horizon.

The HUK 48-strike puts, which are 24.53% OOM, or 67.55% further away than the price that would be represented by the largest observed percentage down move in history in this period, are quoted in today’s market at 70 bid/90 offered. We elect to write five of these at 75 points, our order is filled,and we find ourselves with $1,500 net in pocket, about 357 points The term of the trade is right at 12 weeks, a little longer than we’d like,but we’ve been

impressed by the historical reliability of the seasonal tendency and the current supply/demand situation in this market. We’ve decided that these factors justify accepting a little more time risk present in the slightly extended term of the trade. Our trade will be profitable when HUK stays above approximately 47.35, contest risk included—anywhere above it.

That’s nice enough, and to defeat our trade the market will, again,have to move about 68% further downward than it has ever done before during this time frame. This market’s history complies handily with one of the vital conditions for a non-seasonal that we examined earlier, and this is a very encouraging factor.For the first month, things go well. The weather stays temperate, and Americans are out cruising around burning up gasoline at very un-seasonal rates.

A not-completely-unexpected scandal materializes involving the nowfederalized cretins who imitate inspection personnel at airports, and polls show that the citizens have become even less enamored of air travel than formerly, and are increasing their auto miles driven. HUK rises 4.82 cents to 68.42 and we note with some satisfaction that our short 48-strike puts are now trading at just 21 points.That’s great, but now things start to go wrong.

Over the next four weeks,the Russians decide to buck the OPEC cartel and export as much crude as they want. The President persuades the Congress to relax certain rules involving refineries, and a late-season Siberian Express weather pattern develops and threatens to put Detroit and points east into the deep freeze. All of these developments clearly either increase supply or potential supply, or decrease demand. HUK sells way off, all the way down to 58.40 cents, and we ruefully note the price of our short puts at 105 points. We’re looking at about a $710 open loss.

We still like the possible profit we may earn, but we don’t want to deal with the possibility of a further immediate decline and a sharply rising open loss. It’s time to defend the trade.Starting the Defense:We have two ways to defend this trade using a hedge. We can either sell some number of futures or buy some number of puts having a strike higher than 48.00, perhaps the 53.00 strike.

As far as I’m concerned, the first principle of defense is always to use options for defense when feasible. There is a very good reason for this principle when we defend both non-seasonal trades and WOOM option writes in general. If the market should whipsaw,in this example turning back higher, our cost of defense will be much, much lower. Here, if we defend by selling one single futures contract against our five short 48 puts and the market moves back up 300 points, 3.00 cents, we’re in deep, er, weeds. We will have an additional open loss of $1,260, less whatever amount the short 48 put options decline during the whipsaw.