Should I hedge?
I always prefer to hedge, in my opinion it’s a great way to consistently aim for that 3-5% gain instead of the higher risk/reward plays that may bring in 100% gain, but more often than not will sell for a loss. I always like to have some portfolio-wide THETA helping my account out. I keep my portfolio THETA at around 0.5-1% of my account value. This means if all stock prices stay the same I am gaining 0.5% to 1% DAILY in THETA decay. Obviously this THETA value changes continuously as the market is open, but that is the goal. In my opinion, it’s a great way to mix things up and not ONLY rely on stonks to go up, sometimes they go sideways.
Hedging shares: My favorite way to hedge shares is to enter covered calls. I sell covered calls on a green day or when my position is slightly green to protect downside risk.
One of my favorite plays: The Poor Man’s Covered Call (PMCC). This is a bullish strategy where you purchase a long-dated call (at least 3 months to a year, maybe longer if you want). If you want to play it safer, you buy in-the-money HIGHER DELTA calls (maybe 0.7-0.9 DELTA), which reacts to stock price changes similarly to owning shares, higher risk would be purchasing at-the-money calls where DELTA will be around 0.50. What does this mean? As a call gets more in-the-money, the DELTA will increase which means for every 1 dollar increase in the stock price the option price will increase by the same DELTA.
In this PMCC let’s use AAPL as an example. We can purchase March 2021 $500 CALLS (pre-split price) for roughly $60 (or $6,000.) Now, what we can do is sell the September 11 2020 $540 CALLS for $10 (or $1,000). This is called a diagonal because the long call is much further out in expiration and the short call is 1-4 weeks. Here are some scenarios on how our play will make or lose money.
- If AAPL rockets up 10% to $550 by September 11 (12 trading days away) we can either:
A) Close the position at a very minimal gain (our long-term calls will have gained more than we lost on the short-term calls). Closing out all positions.
B) Roll out the expiration of the SHORT covered call to October 2020 for a higher premium that will off-set the losses from the previous short-leg rising in price. Here we keep positions open and hope the next leg expires worthless (and also that the stock keeps going up). Typically you can keep rolling up the strike and out the expiration until you’ve reached the same expiration date as the long-call.
- If AAPL doesn’t reach $540 by September 11, we collect the $1,000 premium and have just averaged down our long position. The net cost of our long call has been reduced from $6,000 to $5,000 by selling that covered call. Now we can sell another short-term covered call to re-start the process.
- If AAPL tanks and goes down in the short-term, we can let the short covered-call expire worthless & collect the premium, or we can close if out for 60-80% gain if you are expecting the stock to bounce back up in the short-term, where you can re-enter another covered-call, but at a better price and also collecting more premium.
- Similar to #3, if AAPL stays flat, we simply collect the premium from the covered-call when it expires worthless or if we get a 60-80% gain we close it out and roll out to further date or wait for a bounce.
A few things I like to keep an eye on when doing the PMCC are:
- #1 on this list is going to be assignment risk in the case that the stock price rockets up past your short call. You don’t want to be losing any money in the case that your long call gets called away from your short leg.
- Be sure the THETA from the short covered-call is higher than your long call. You don’t want to be losing value to THETA on this.
- Your long call will have a positive DELTA, your short call will have a negative DELTA. If the short call reaches the same negative amount of DELTA from the long-call then you need to roll up and out or close the position. At that point you are losing more value as the stock continues to go up.
- Going back to #1, before entering the diagonal spread, be sure your assignment risk will still leave you profitable should you lose your shares/long-call. Again using the example from above, if we paid $60 for the $500 calls, our break-even point is $560 on those calls. If we are selling short term covered calls at $520 strike for $20 then our break-even on the short covered call is $540, meaning we lose the difference of $560 to $540 of $20 should the stock go up a lot. That means we want to be selling the short-term $550/560 strike to minimize any losses should the stock have a meteoric rise. Once the position has been averaged down once or twice you can start selling .15/.20 delta strike covered calls to collect a little better premium with still a low risk of getting assigned. If you do get assigned you do so profitably, earning a solid 10% per play with a lower risk is a great way to get more wins on a consistent basis.
In my opinion, I use hedging because:
- Hedging protects me if the stock decides to go sideways for an undetermined amount of time.
- Hedging adds THETA to my account where I can collect premium on my positions. You face assignment risk, but if you learn how to avoid assignment risk by rolling positions and understanding the THETA/DELTA between your long and short positions, it can be avoided for a small price while keeping most gains.
- If you are holding shares long-term, hedging using covered calls acts like dividend investing where you can collect premium consistently.