A Simplified Hedge Plan

This is a crude example of hedged trade plan. Perhaps at some point I'll get Screencast, but for now bear with me.

My expectation is for price to reach the 1325 area, highlighted in purple, on the S&P cash, which is an area of confluence on the daily chart. This type of set up is rare and can be quite powerful.

I want to be long around 1325, but will use this hedging strategy with either SPY or OEX weekly calls to start accumulating them today.

Price never travels in a straight line, so the technique uses the defined option risk for your speculation -- that the market will bounce hard once it reaches the confluence area -- and as the market bounces on its ride to the target, you then hedge with the much higher delta leveraged short ETF or e-mini. I've tried to show buys with green dots and hedges with red dots. Sorry if it's too corny.

Note that an at-the-money OEX option moves half as much per S&P point as an e-mini contract, so you always want to have 50% more calls than e-mini contracts.

What follows is an EXTREMELY simplified example.

If you buy 10 OEX calls at $2.00 and the market bounces 6 points into overhead resistance but still does not break out, the calls may be worth $5.00. You can scale out of 4 and pocket $1200, then hedge your 6 remaining calls with 3 e-minis, a 50% hedge in case you're wrong. Notice you've now got free calls. Then, the market breaks down another 10 points. The e-minis make $500 per contract, or $1500. Sell the e-minis and buy more calls at $1.50 with the profits. Notice how you are accumulating a larger and larger spec position for very little risk.

That's the hedging plan in a nutshell.

In practice, it's not so easy, but it works. All you need is one big success from a strong area of confluence, which in this week's case is occurring on the daily chart and could yield at least a 60 point multi-day pop in the S&P or a possible resumption of the uptrend. Being long 50 OEX calls near-the-money could earn you multiples of your investment in a matter of hours.

If 20 of those points occur on a Friday afternoon, OEX calls can easily go from $1.00 to over $12.00. It can and does happen.

It is because of the weekly expiration of the OEX calls that you get explosive premium expansion due to their time value when they become in-the-money. I also like to simultaneously accumulate front month SPY calls with longer time value to capture multi-day moves after the OEX weeklies expire. They only move a 1/10th of the S&P, but you can still earn 2-3X your money over a few days.

Also note that this hedge technique can be used with any market that has options. I have been using it very successfully with the Canadian dollar recently. I've been buying USDCAD which means that I'm long dollars against the Canadian dollar, thus short CAD. Against this position, I've been going long 6C, the Canadian dollar futures contract, when it gets deeply oversold.

So far, by scaling into and out of USDCAD, I'm up a few hundred pips, but the real money has been with the 6C where the profits have provided a large cushion against any possible loss on USDCAD.

Bottom line: today I'm watching 1325 on the S&P cash. With any luck, the OEX 595 calls will be about $1.50-$2.00 if we get there.