Trading the S&P – Using Puts to Hedge the Upside

In the current paragon options portfolio, year to date we are up 35% and we currently have a December risk reversal in the S&P 500. This position was set up a couple of months ago looking for the S&P to move lower into Christmas. The strikes that were used were long puts at 2800 and short calls at 3050. We have hedged this position in order to protect our profits and are looking for a reversal in the short term.

The position would have risk on an expiry above 3050. The position was put on when the S&P was trading at around 2950 and has a 57 Delta. This means that the position was effectively short half a future and on any move down would start to become profitable almost immediately. The upside is a mirror version with us losing money at the rate of half the future although in truth no loss is realized unless we expire above 3050.

This type of trade where one buys out of the money puts a sells out of the money calls is known as a risk reversal. This type of options strategy can be very profitable at market turns and allows you a margin of error when trying to catch the turn as your short position is usually well out of the money. You can see a diagram of this position below.

In the three or four weeks that followed us entering this position we had a slow drift up in equities that we had not anticipated as we were looking for a move lower. This meant that on paper the risk reversal was starting to lose money as we got closer and closer to our 3050 strike. Upon reaching 3040 we saw a short term move lower coming which we thought would be short lived before a move back to new highs. We decided to take advantage of this move to hedge our position by reducing delta and increasing our long theta burn (time decay).

You can see in the diagram below the trade that we put on which was selling an equal amount of 2950 puts against 3050 calls. This effectively created a 2950/3050 short strangle and the puts from the original risk reversal now became a hedge against the 2950 short puts effectively creating a bull put spread.

By selling the 2950 puts we took a credit of $35 a lot.  The idea behind this was that we can use the premium from the puts to hedge the calls to the upside because as mentioned above we were looking for an upside move to resume. So, effectively, the breakeven on the 3050 calls has now moved to 3085 (3050+35).

The sale of the puts was a bullish move as selling puts is always bullish.  This and the fact of having the delta of the position halve from 56 to around 27 to around meant that our exposure was cut should the S&P continue to move higher which it has since done. Additionally because we are now short of strangle we have increased our theta burn and can make a very healthy profit of around $7000 should the mini expire between 2950 and 3050.

This strategy is a good demonstration on how you can hedge upside by selling down side as long as you understand the risks. In our case the puts were hedged by the now-defunct risk reversal and as the delta was halved the position moves a lot more slowly and is once again easy to manage. The daily theta burn collects cash and the slow grind up in equities has meant the volatility has fallen, further crushing the strangle.

Lastly on a breach of 3085 a loss will occur at expiry.  Should the mini continue to trade higher we may need to hedge the position further although we are looking for an imminent reversal as the S&P is extremely stretched at these levels.

To find out more about Paragon Options, please see this link for more information.

Written by:

Matt Gardiner

Matt is a highly experienced options trader of 17 years, having been a private client broker and an inter-dealer broker in the city of London as well as working internationally in Australia during the commodities boom. His specialty is a sophisticated use of options to create portfolios or “books” of options using multiple time frames, strikes and varying quantities.

07th Nov 2019

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