Many traders with spread trades that are going against them ask if there is a way to hedge their position. Let’s first look at the mess they’ve gotten themselves into and then possible solutions.
Step one; You have a bias or trade plan that is starting to fail. Lets assume you collected $1 on a $5 wide vertical credit Call spread (ex: 20c/25c) and now spot price has risen above your long strike. You’ve already paid for a hedge against a naked $20 Call by purchasing the lower priced $25 Call. There is NOTHING you can do to improve this trade outside of adding more risk.
Step two; Has you bias changed? If not, then maybe you just need to give the trade more time to come back but if it has changed, and more importantly WHEN it changed, you need to manage your position. If your bias changed because of market action, then you need to admit that your initial bias was incorrect.
So what can be done?
In this example the greeks are working in your favor as there is now more extrinsic value in your long than your short. Close out here to prevent max loss if you are now unsure of your bias. If your bias has changed and you think a max loss is a high probability AND you’re comfortable adding risk, here are things you can do
- Buy additional long Calls. Throwing capital at the trade in hopes that it keeps running counter to your initial assumption, but adds no more risk.
- Buy to close some of the original short Calls. Risk is the value in the unpaired Long Calls expiring worthless
- Sell some of your long Calls. Close these out when they still have high extrinsic if you think that spot doesn’t rise much more
In each case you’ll be adding either more capital or more risk to ‘save’ the trade. Unless your bias for the time remaining in the trade is as strong or stronger than when opened, my style leans towards just letting the trade run its course or close out for capital preservation. The cost of any hedge is the same as if you had simply traded smaller to begin with (actually more once you account for commissions and B/A spreads)