The time comes in every trader's life when he/she wants to express a particular opinion on the market and can't find the appropriate asset or hedge for the trade.
Before bailing on the idea altogether, a trader might consider investigating alternative hedges for their intended position. In some cases, a somewhat non-traditional structure may adequately meet the capital and risk requirements of the idea.
The notion of cross-product hedging was recently covered on an episode of Closing the Gap that provides some good examples of this concept in practice.
On the show, the tastytrade team uses some examples from the single-stock equity and options universe to provide more details on this type of strategic thinking.
Before jumping into the cross-product hedging pool, it's useful to briefly review the concept of a “delta-neutral” position or portfolio.
A delta-neutral position consists of offsetting positive and negative delta trades that yield a net zero delta position. Delta-neutral trading is very common in the volatility world because it removes a good portion of the directional component in a trade and helps to ensure a trader is locking in the level of volatility they are trying to buy or sell.
While the directional risk of a position will be dampened in a volatility-based delta-neutral trade, the degree of movement of course will not be. For a short premium trade, the position will perform the best when the underlying remains near the strike. For a long premium position, a delta-neutral volatility-based trade will of course perform the best the further the stock goes from the strike.
Looking at an example of these concepts in practice, imagine that you have bought 100 at-the-money call contracts with a .50 delta. If you wanted to hedge this position according to the delta-neutral model, you would then sell 5000 shares against the call position.
The number of shares to be sold (offsetting deltas) is calculated by taking the number of call contracts and multiplying it by the delta and then the contract multiplier (100 shares per contract).
The equation is therefore: 100 x .5 x 100 = 5,000 deltas (shares)
The offsetting aspect of the deltas in this example are therefore +5,000 deltas from the 100 call contracts that have .50 delta and -5,000 deltas from the shares sold against it.
Going back to the aforementioned episode of Closing the Gap, the hosts of the show tweak the model of hedging with the underlying stock of an option by instead hedging with the underlying of a different, but highly correlated, stock.
First, the guys go over a simple example involving long stock and the number of call contracts a trader would sell against his/her position to get delta neutral.
Consider for example, that a trader is long 1,000 shares of stock and wants to know how many call contracts to sell against it. Let's say the trader wanted to sell a 1.0 delta option against their 1,000 share position in the underlying.
Calculating the number of options contracts to sell means that part of the equation is now the unknown variable (let's call it "Y").
Consequently, our equation is Y x 1.0 x 100 = 1000 or 1000/100 = Y or Y = 10
The result is that 10 contracts of an option with 1.0 delta will hedge 1,000 shares of an underlying position - this means the trader needs to sell 10 contracts.
If a trader sells fewer than 10 contracts, he/she is under-hedged, if more than 10 are executed, then the position is considered over-hedged.
On Closing the Gap, the on-air team then introduces EBAY as an example where they would like to initiate a delta-neutral option trade, but don't feel the selection of available option strikes meets their needs. Instead, they decide to consider a stock that is highly correlated with EBAY to deploy the delta leg of the trade.
As indicated on the episode, Apple (AAPL) correlation with EBAY measures in very high at .91 (1.00 indicates a perfect correlation).
Taking a theoretical long position of 1,000 shares in EBAY, the guys then explore trading a short delta position in AAPL options to create a cross-product delta neutral hedge.
It's important to note that while these two stocks are highly correlated, they are unique companies and are therefore subject to risks specific to their companies.
For this reason, the Closing the Gap team trades call spreads in AAPL as opposed to selling naked calls. The short-premium call spread achieves the goal of deploying short deltas in the correlated stock while limiting risk through a spread with a known maximum loss. They have also elected to under-hedge their position, making it somewhat more bullish than otherwise.
Shown below is their hypothetical method of hedging 10% of the EBAY long delta risk with a short premium AAPL call spread:
As you can see from the above, the team uses three different examples of Apple call spreads with 1, 2, and 3 points between strikes. The greater the distance between strikes, the greater the offsetting delta will be from the spread - as is the risk in terms of profit and loss.
The cross-hedging discussion on this episode is concluded with the team pointing out that BABA has a similarly high correlation with EBAY and a higher Implied Volatility Rank (IVR).
The takeaways from this exercise are therefore:
- We can reduce the cost basis of long stock positions by selling calls.
- If sufficient premium is not available, or liquidity is poor, we can look for opportunity in highly correlated underlyings.
- Call spreads provide the opportunity to reduce cost basis, while protecting us from naked cross-product short premium risk.
If you have any questions about cross-product hedging, we encourage you to watch the entire episode of Closing the Gap focusing on this subject.
Additionally, we welcome you to follow up with any questions or comments at email@example.com
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.