How to Solve the Risk Hedge Problem in Options

Focus: OPTIONS

Michael Thomsett Image Michael Thomsett Founder, Thomsett Publishing Website

Every trader faces the struggle of creating profits while reducing losses. With options, swing trading is one method for creating short-term exposure, but even then the risk problem is not resolved, writes Michael Thomsett of ThomsettOptions.com.

The purpose to swing trading is not to take a position in the market but to maximize trading gains while reducing losses. I have found one solution that I have tried out several times. I call this the "hedge matrix."

The strategy is based on opening what I call the 1-2-3 iron butterfly. It has several components. The iron butterfly is one of those strategies designed to limit maximum losses and gains. It consists of opening long OTM puts and calls and offsetting these with ATM short puts and calls. In the typical iron butterfly, three strike and four contracts are involved. For example, if the ATM is 45, you may open a long 42.50 put, a long 47.50 call, a short 45 put and a short 45 call.

This iron butterfly is attractive to many traders, but expanding it into a 1-2-3 iron butterfly creates a very interesting hedge.

The 1-2-3 iron butterfly has three different sets of butterflies, one in each of the next three expiration months. The ideal time to open this is right after ex-dividend date, to avoid early exercise of any ITM calls.