A hedge thought...

Had a thought about how to reduce losses on basic options plays when it goes against me, while at the same time adding profits in most cases where it goes sideways or with me. Haven't tried this yet - still thinking about it, but it seems like it should work.

I typically do options 3+ months out and in the money. Right now, I'm in June 22 $27.50 calls on WLT. WLT also has weeklies, and that's where my thought began.

Since I own the June 22 $27.50 calls, why not sell the March 22 $35.00 call? My exit point is around $35 anyway. What I'm effectively doing is limiting my profits to whatever the June calls are worth when the stock hits $35 - because after $35, the short leg (the leg I sold - the March $35 calls) go in the money, and start costing me penny-for-penny. In reality, I'd probably lose money after $35, because the March calls have a 1.0 delta at that point, but the June calls will have less than a 1.0 delta.

Here's what I can see happening....

If the play goes against me, I need to reverse both legs. The leg I bought will be worth less than what I paid, so I'll lose a little bit. However, the leg I sold will also be worth less, and will have time value deteriorating rapidly, so it should be worth a lot less than what I sold it for, so I should make money on the short leg. In this case, the strategy buffered the loss a little - lost a little less on the play.

If the play goes sideways for a while and I want to stay in, I've made some money on the short leg. The short leg will expire worthless on Friday, and I can do it all again next week. In this case, the strategy has added profit to the overall play.

If the play goes sideways for a while and I want to get out, I need to reverse both legs. The short leg is out of the money and expires in a week, so it's value is evaporating rapidly. I should be able to reverse both legs for either a small profit or small loss. In this case, the strategy probably didn't help that much, but it probably didn't hurt either.

If the play goes with me up to the strike price of the short leg, I can let the short leg expire worthless then sell the long leg for the original target profit. Alternatively, I can reverse both legs on Thursday or Friday, and the short leg should be worth less than what I sold it for, which makes it an additional profit on the overall play. In either case, this strategy has added profit to the overall play.

If the play goes with me, but goes beyond the strike price of the short leg, I need to reverse both legs. Actually, I should reverse both legs before the short leg goes in the money. Because of the different expiration dates, the short leg's delta will reach 1.0 when it goes in the money, but the long leg's delta will probably be around .7. That effectively means I'll be losing $.30/share for each dollar the stock moves beyond the strike price of the short leg. In other words, if it moves up to $36, it will cost me an extra $1/share to buy back the short leg, but the long leg will have only gained about $.70/share - which is a net loss of $.30/share. In this case, the strategy begins to eat into profits once the stock goes beyond the strike price.