I’ve been working on hedging one of my client’s accounts this week with various option combinations. After the market closed yesterday, I realized the IWM trade I made for him could be a good trade for me too. I finally found time this afternoon to focus on my account and made the following trades.
While IWM was trading at $122.78, I bought two IWM January 2016 $124 puts for $10.00 each and sold two IWM January 2016 $110 puts for $4.94 each. I paid $1,014.44, including $2.44 in commission, for the spread. Immediately after this order hit, while IWM was trading at $122.76, I sold two IWM June $122 naked puts for $3.93 each and received $785.14 after paying $0.86 in commission. All combined, I had a net debit of $229.30.
The beauty of this combination is that I can’t lose more than $229.30 (outside of a severe correction), but could make $1500-2,000, maybe more if I luck out on the price swings. If IWM falls before my June puts expire, I could be assigned 200 shares, but my long puts from the January spread would have a $2.00 net gain ($124-$122). Since I have two long puts, the decline in IWM’s price would an extra $400 in my favor, taking my $229.30 debit to a $170.70 paper profit. At that point, I could start selling covered calls on my newly acquired 200 shares and further increase my profit.
If assigned, my cost per share, including all of these premiums, would be $123.15 ($122 June puts assignment + $1.15 per share net premium cost). I could exercise my January $124 puts at any time after assignment to take a profit, but I’d lose my hedge. Instead, I’d rather keep my hedge in place all of the way down to my $110 short puts, which is a little more than 10.6{01de1f41f0433b1b992b12aafb3b1fe281a5c9ee7cd5232385403e933e277ce6} below my potential cost per share and 12.9{01de1f41f0433b1b992b12aafb3b1fe281a5c9ee7cd5232385403e933e277ce6} below IWM’s high hit on March 24. I don’t think we’ll see a correction on IWM much deeper than $110 this year and if we do, I think it’ll be time to start buying again.
The real risk in this trade is that IWM could move higher quickly and my hedge would fall farther out of the money. Every two to three months, I would have to use higher strikes on my new naked puts to get a good return. I’m not concerned about being able to turn this trade into a profit. I’m more concerned with how much of a bite the hedge could take from my naked puts’ returns. The VIX is at 15.50 right now. An increase in volatility would help me while a further easing of volatility would hurt me. I expect to get a little of both sides of volatility by January 2016.
I have nearly 10 months for my January puts to play out and IWM is only up 2.5{01de1f41f0433b1b992b12aafb3b1fe281a5c9ee7cd5232385403e933e277ce6} so far this year. Small caps could have a lot more upside before we see a correction, so I’ll have to put a lot of thought into my next naked puts. I’ll be able to take some more risk since I’ll have solid protection built in and paid for. I’ll continue to avoid high-risk trades. If IWM makes it to $130, the short puts from my January spread would be 15{01de1f41f0433b1b992b12aafb3b1fe281a5c9ee7cd5232385403e933e277ce6} out of the money, which would help my probability of not being caught on the bottom side of my option combination.
I plan to add in more trades like this throughout 2015 with the expectation that we’ll see a correction sometime before the end of 2016. If I start laddering in cheap hedges now, I’ll should have good protection whenever the next storm hits.
SOURCE: My Trader’s Journal – Read entire story here.
