Top Three Ways To Hedge With Options

What if the market comes apart, how can you protect yourself using options?

Ok, so we have FOMC Wednesday, September 22.  What do we do and what can we expect?  First, let me start by saying I don’t think the FED will say anything that will be earth-shattering.  They already pushed the dreaded tapering off until Nov and they will probably use the transitory term to lighten the concerns of inflation, the US, and world economies (think of China).  I also think they will point to better-than-expected inflation numbers and how things were not as bad as projected.  SO what is one to do?

If you are a stock trader chances are you may still have considerable risk on the table.  With the recent semi-market meltdown (Note the markets only fell about 5% since the market high about 2 weeks ago) there may be traders stuck in long positions. 

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So this begs the question.  What do you do?  Are you sucked down into oblivion with the impending black swan?  Do you cut your losses now and get out and hide?  Or do you try to find a way to protect yourself and minimize your losses?  If you are like me you never like to lose and I am one to never throw in the towel.  If this is you then you can “leverage” options to hedge.  The problem here is most do not understand how to hedge with options.  So here are some “options” on how to use options to hedge.

  1. Use the VIX!  We have all heard this before but the cold truth is many do not understand volatility nor how to hedge with the VIX.  The best way is to use the actual VIX not the spin-off derivative products like UVXY and VXX.  What I do is I will buy a debit spread 6 months out and then finance it by selling a put credit spread.  Yes, this is a 4 leg custom position but usually, if you do this right you can do this for little to no cost and sometimes for a small credit. 
  2. Use BackRatio spreads!  Most have NO idea what this is or how they work.  If you are that person check out our service we do these all the time.  You essentially sell an ATM option and then buy two OTM options but to the downside.  The key here is you can do BackRatios to the upside but when volatility crushes (you are a net buyer in this spread) you get sucked into what I call the negative valley of death.  The reverse is true to the downside.  As the underlying goes down volatility rises and thus this expansion helps your positions (because we are net buyers). 
  3. Break up your options positions if you are in spreads.  Get out of positions when they are favorable for that part of your spread think the legs of an iron condor.  Or you can roll the unchallenged leg of the iron condor.  You can break up butterflies and sell the profitable parts then when the stock reverses for a day you get out of the other side without the boat anchor pulling you down. 

Every day on  Options Trading Signals we do defined risk trades that protect us from black swan events 24/7.  Many may think that is what stop losses are for.  Well, remember the markets are only open about 1/3 of the hours in a day.  Therefore, a stop loss only protects you for 1/3 of each day.  Stocks can gap up or down.  With options, you are always protected because we do defined risk in a spread.  We cover with multiple legs which are always on once you own.   

Enjoy your day!

Chris Vermeulen
Founder & Chief Market Strategist