Hedging with the Ratio Backspread

I know I promised Vertical Spread Adjustment strategies as the next topic. I’m going to delay it one week and at the request of the people who asked, instead present a written version of the presentation I delivered last weekend in Denver at the Trading Trainer Mastermind. At the time I was putting my PowerPoint together, we were just entering earnings season. Given the daily market behavior over the last week has every day behaving like an earnings announcement, it appears an appropriate time to share this hedging strategy.

This past earnings season, I’ve heard a lot of questions about how to best hedge a long trend continuation position thru an earnings announcement. In my mind, carrying this type of trade thru earnings transforms it into something considerably more speculative than when the trade originated. This kind of transformation, in general takes form in the expansion of risk. Since the likelihood of a significant move against the position is large, the amount of capital originally allocated to the position is likely no longer appropriate. To carry a trade thru earnings on a stock that has a history of significant moves, requires the trader either to reduce capital and/ or hedge against the original position.

Along with just about every Apprentice. I bought into EL when it followed thru on the Reactive Template on April 14 th. I bought the July 65 Calls at $4.69. At the close of April 26 th. the day before earnings, the July 65 Call was worth $6.60 for a 41% profit. To gauge whether or not to hold this trade thru earnings, let’s determine our risk.

The first thing we need to know is how much a vehicle typically moves on earnings. The easiest thing to do is pop open a chart and look at the maximum moves that happened over the previous years’ announcements. To get into specifics, I use www.optionslam.com. With a free membership, Optionslam will display the Max price moves for the previous year’s earnings. We can estimate the size of the earnings move by taking an average of these values and converting them to a dollar figure.

In the case of EL, 1.58 + 10.45 + 2.94 + 18.85 divided by 4 yields an average max move of 8.45%. Multiplying this number by the price of EL at the close of the 26 th ($69.98), we get a max move of $5.90.

Another way to estimate an earnings move is to look at cost of the front month Straddle. In general, the Straddle price will give you the options market’s estimate of what the expected move will be—in most cases, a very similar number to the average of previous moves. In the case of EL, the price for the May 70 Straddle on April 26 th was $4.90. It seems clear the options market is discounting the 18+% move of May 2009, but for our purposes of determining risk, it is best to plan for the larger move of $5.90.

Below is the risk graph of the long call the day before expiration showing a lot size of 2 contracts, for an entire cost basis of $938 (excluding commissions). I’ve drawn in a price slice at the close of the 26 th ($69.98) and at a $5.90 drop ($64.08). Click on the graph to enlarge it.

It is clear that even without taking into account any changes in volatility (these changes will be minimal since we are long the July option), that the drop to $64.08 will turn a very profitable position into a loss of about $340, or 36%. Of course, a $5.90 rise, would create a home run, but the 36% loss is too much risk.

To reduce this risk, we can reduce risk by either removing the entire position (which is what I ultimately did), removing part of the position or hedging against the position. Converting this trade into a Ratio Backspread will both reduce capital and provide a downside hedge. In this example, the Backspread is a combination of a Long Call and a Vertical Bear Debit Spread. This is very easy to do: simply sell one July 60 Call for every two of the July 65’s that we are long.

At the close of April 26 th. the Jul 60 Call was selling for $10.50. Note that one contract of the 60 Call is worth more than we paid for the two contracts of the 65 Call: by selling this Call, we essentially lock in $1.12 of profit. You can see this on the risk graph below.

If the world ends and EL crashes, our worst case scenario is a gain is a $112 gain. If EL breaks upwards, we have unlimited profits. The worst thing that can happen is EL drops mildly and we let time decay away our position. But this position is a temporary hedge against an overnight disaster and is three months out, so time decay and/or a volatility collapse are not big concerns. The Ratio Backspread does two things to protect us:

It reduces the overall capital in the position. In this example, by selling the 60 Call, the total capital dropped by two thirds: from $938 to $388. It protects against a downside move without limiting upside potential. In the risk graph above, you can see that a $5.90 drop down to $64.08 does better than cutting the 36% risk – it leaves us in a profitable trade without killing the potential for gains, should things break in our direction.

As it turns out, EL did break down on the earnings announcement, dropping $5.33 points to a low of $64.65 right after the open. The July 65 Call was valued at $3.30 at that point (and closed the day at $4.40). Had you carried an un-hedged position thru earnings and closed it after the open, your realized loss would have been $278 or 29.6%. If for some reason, you waited until the end of day, you’d have suffered a $58 or 6.2% loss. The Ratio Backspread however, had you exiting the trade at the low for a $115 profit or 12.3% (based on the original margin of $938) or at the end of day, with $172 (18%) in gains.

To summarize – You can easily create a hedge from a long position (whether profitable or not), by selling one strike deeper in the money than your existing long to create a Ratio Backspread. The ratio need not be 2:1 as we’ve done here, but could be 3:2 or 5:3 or any other configuration that your risk mandates. In the example above, we looked at the Backspread’s use during earnings, but it can be used to hedge against anything — uncertain market conditions, an FOMC or some other event or piece of news. Over the last couple of nights, some apprentices have held breakout entries overnight and seen great profits dissipate and even disappear into losses. For anyone looking to carry a trade overnight during this European fiscal craziness, consider analyzing the backspread as your hedge.

As promised, I’ll discuss Vertical Spread position management. As always, feel free to post any questions. I’ve actually figured out how to read the comments this time around. If anyone is interested in automating your trading practice and trading with AJ using the new Advanced Alerts with Charts of Interest Interface, I shoot me an e-mail at info@optionworkshop.com and I’ll sign you up.

Current Apprentices: we’ll soon have the Group Log Tool Interface up and running so you can automate your group consensus hot list picks!