How I exit hedged positions

This has been a brutal month for bull plays. The market's reversal to the downside on May 22 and subsequent 4.5% decline has produced exit signals on 12 of my 15 bull holdings.

An exit signal on shares is quite easy to deal with: Close the position immediately. Long shares have unlimited upside profit, but also the potential for loss all the way down to zero. Although they never expire and can be held as long as the stock is traded, enough of a decline produces a zombie position, so far in loss territory that it's barely worth dealing with.

But I generally don't trade shares. My preferred vehicle is a hedged position composed of vertical credit option spreads: Bull put spreads for trades to the upside and bear call spread for downside trades.

And the complexity of vertical credit spreads means that exit decisions become a matter of staging a tactical retreat rather than fleeing the battlefield willy-nilly as with shares.

The Investopedia article on vertical credit spreads can be read here.

Vertical credit spreads have maximum gain and loss. When the of the stock is above the break-even level, then the spread makes money with the passage of time. If it's below, then the spread loses money day by day.

A bull position can produce an exit signal, by the stock price moving below the 10-day price channel, while still being above the break-even level -- exiting with a profit. Or the decline can put the position into loss territory. Each exit signal and the condition of the vertical credit spreads is unique to the moment.

In Trader Heaven, of course, I would know which spreads to exit immediately and which to hold so I can profit from the passage of time.

In real-world trading, I find that have no idea which way a stock is going to move. All I know is the present price, the break-even level on my spreads and the points of maximum profit and loss.

Since I don't know the future direction of the stock price, the only means I have of crafting a tactical exit is to use the Reward/Risk Ratio, which asks: Do I have more to gain or lose by continuing to hold the position?

Since vertical credit spreads are also built out of options, I have another piece of information available to me: Implied volatility. This statistic tells me that options traders are pricing in confidence that 68.2% of trades will fall within a certain price range (statistically, one standard deviation) within a certain period of time.

An Investopedia article on implied volatility can be read here.

The period of time used on charts for implied volatility is one year. For the stock analyses that I post, I provide two ranges, one for a month out and the other for a week.

But for exit decisions, I find it useful to be more precise. I calculate the implied volatility for the remaining life of the options, up to expiration. As of today, for example, my June vertical credit spreads that have been battered so heavily have 16 days to live.

With that information in place, I can now calculate the reward/risk ratio for the implied volatility range and the remaining life of the options.

First, I calculate the range. I hold vertical credit spreads on Google (GOOG), which as of Wednesday's close had implied volatility of 0.2634 and was selling for $859.70. Options are pricing in confidence that 68.2% of GOOG trades will fall between $812.29 and $907.11 over the next 16 days.

In the example below, the numbers I use are very specific to my mix of option spreads on GOOG.

I calculate:

• The current risk, or the cost of selling the spread now. (For GOOG, that's a loss of $784.11.)
• The high boundary risk, or the cost of holding the spread until expiration if the stock closes on expiration day at the upper boundary of the implied volatility range. (GOOG: gain of 1,541.)
• The low boundary risk, or the cost of holding the spread until expiration if the stock closes on expiration day at the lower boundary of the implied volatility range. (GOOG: loss of $2,459.)

In other words, if I sell now it costs me $784 plus change, if the stock price reverses I have a two-thirds chance of showing a $1,541 profit, and if it continues to fall, I have a two-thirds chance of losing a painful $2,459.

As my next step, I then subtract the upside risk the current risk from the high boundary risk and also from the low boundary risk, getting a distance for each direction. That distance is my risk either way compared to my cost (or gain) if I exit now.

For GOOG, that worked out to $2,325.11 for the upside distance and $1,674.89 for the downside distance. 

At this point, it's clear that I have more to gain than to lose from where things are now. Putting those numbers into a ratio makes it precise: Upside distance divided by downside distance equals the Reward/Risk Ratio.

For my GOOG positions, it works out to 1.4, or a 40% better reward if the stock rises than my loss if the stock falls.

My general preference is to close immediately if the Reward/Risk Ratio is below 1, and to hold the position if it's above 1. Note that it's a preference, not a rule. A clearly awful panic to the downside on the chart will prompt me to ignore a ratio above 1 and exit immediately. Or I might continue to hold if the chart looks like a reversal to the upside is at hand, even if the ratio is below 1.

GOOG for the last three days has traded within the range set by a decline the fourth day prior, suggesting the decline is pausing. So I'll hold GOOG for now, but will continue to do the calculations and change my mind if conditions warrant.

A Google Docs spreadsheet with the calculations I used can be found here.

Certainly, I could treat spreads the way I do shares: Exit immediately. But option spreads are not only hedged, their leveraged, so a big loss can turn profitable with just a small move of the share price.

Again, using GOOG as my example. The break-even point on my spreads is $867.36, or $7.66 above Wednesday's close. The average daily move of the stock over the past 20 trading days has been $15.29.  So I'm actually just a half day's distance away from profit and glory.

Since to trade is to gamble, I'm always willing to take a chance if I find the odds and rewards are in my favor. That's why I do the complex analysis for spreads rather than folding my hand immediately.

References

My trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

The number 68.2%, used with implied volatility in my discussion above, comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.