Volatility and Protecting Gains.
When I have a position that goes well, I try to let it run as much as I can. That being said, I am not willing to give back all my gains, if it will reverse against me. That is why I use Put Options to lock in gains and giving it more room to run as well.
If I'm very bullish I use out of the money puts to cover myself, so I won't reduce the Delta a lot, and as the trade goes in the right direction I roll over my puts to lock in more gains.
When you want to sell put OTM and buy put that is closer to the money, you are buying Vega, which is the option exposure to the implied volatility. So, if you want to do it right, you need also to consider if the volatility is high or low.
I will show that using an example in my GLD trade:
On July 27th as the GLD was up 2% I sold the put 171 I had and bought put 175. I paid for rolling the puts 0.7$ but doing that I locked in 4$ more to my profit:
Now lets see what happened on Jul 28th:
On that day the GLD kept going up, and at the same time the Puts also gained value:
You may think that something is wrong because puts are supposed to profit when the market goes down, not up. This is true in terms of delta, however the volatility spiked up that day, and the option gained more from the volatility than it lost from the delta.
So, if someone decides to roll his position on that day, he will buy high volatility and maybe it is wise to wait for it to come down.
And as you can see from the Skew it did go down in the following days:
SO you need to keep in mind, that sometimes when you are buying options that are with relatively high implied volatility, the market can go in the direction you wanted, but still you will lose money because of decrease in implied volatility.
Being aware of the Skew and how it behaves can give you another edge when trading with options.
And by doing it right you can let it run as much as it wants, and keep on locking gains as the trade goes in your favor.
One last thing to keep in mind is that your margin requirements when you are covered with puts are very small compared to holding the underlying assets alone: (less than 3% in this example). This is because we created a synthetic Call. I explained about synthetic options and the Put-Call parity, in my Options Course.
Go Gold !