Category: Hedging

Bottom fishing or Covered stock?

Q: I am a member of the DMA and had some questions regarding SRS. I want to enter this trade but do not know if I should be bottom fishing it or buying a covered stock, due to the following:

– Bottom Fishing: negative skew / am considering selling the Oct 9 Put / buying Jan 8 Put
– Covered Stock: high IV – for each 100 shares bought I am risking around $140, which seems “expensive”

Any thoughts you can share with them. Is there another alternative I could be considering?

A: It depends on whether you are bearish or bullish on srs.

The ‘bottom fishing’ trade you mentioned is bearish. You will only make a profit is srs falls to 9 (max profit). You max loss is the debit you pay for the spread and you will have a max loss if srs rises by the October expiration.

If you’re bullish I would recommend the covered stock rather than the diagonal position.

The reason why the covered stock is seemingly expensive is because srs has a high beta (high volatlity) so the premiums are generally high but you can adjust the risk by going deeper into the money on the put side.

You didn’t say what strikes you were going to use for your covered position… but I would look for a put with an .80 delta if you want to reduce your downside risk – you’ll pay a little more for the protection but if srs declines you will have good protection.
You’ll also get unlimited upside potential if srs continues to rise.

Hedging with a synthetic stock position

Q: You discuss hedging SRS with a synthetic stock position in IYR. My question is why not do a short synthetic position in SRS, Sell call and buy puts. I have noticed people in the TOS chat room talking about shorting AIG this way versus borrowing stock to short. This way you would have along and short position in the same stock. thanks in advance.

A: AIG is a different story because there is no corresponding ‘short’ AIG etf with calls and puts. So your only hedging option is to sell calls and buy puts.

There are 4 reasons I’m using IYR to hedge instead of a collar (a “collar” is ‘selling calls and ‘buying puts’ on a stock you own) on SRS:

1) If I sell calls on SRS they can take my stock away if srs surges and they are in-the-money thereby losing my position that I was able to purchase at much lower prices.

2) If my puts on IYR are assigned I have long IYR stock which is a hedge in itself – it’s equivalent to having a deep -in-the-money put on SRS. It does require more margin however.

3) IYR and SRS are very tightly correlated – srs is exactly 2X the move of IYR.
I know ahead of time what my exact risk is and I can scale in or out and be long or short my hedge by simply adding a few contracts.

4) The theta is positive (I set it up so that the option I sold is slightly higher in price than the one I bought) so I collect money if the stocks do nothing.