Hedging Principles on thinkorswim®

The following content is intended for sophisticated options traders with substantial options knowledge. If you're not familiar with the terminology in this article, please review our options content for beginners available to Schwab clients.

Like all our strategy discussions, this content is strictly for educational purposes only. It is not, and should not be considered individualized advice or a recommendation. Options trading involves significant risks and is not suitable for everyone. Certain requirements must be met to trade options through Schwab. Not all clients will qualify.

Stock, bonds, cash—that's an investor's standard menu. They might allocate, say, 70% of their money to stocks, 20% to bonds, and keep 10% in cash. The assumption is that stocks and bonds are somewhat uncorrelated, meaning they don't move up and down at the same time. If stocks experience a period of negative returns, bonds might potentially move in the opposite direction, and vice versa. And cash will just stay cash. Investors often fine-tune asset allocations every month, every quarter, or less often based on factors like risk tolerance, goals, time horizons, and market outlooks.

While a long-term investor often has asset allocations at the top of the mind, a trader might seek an approach that adds agility to their portfolio. No, we're not saying a long-term investor should turn into a trader. Rather, knowing what a trader does can help an investor be more informed. In that respect, some traders think in terms of three primary concepts to manage, or hedge, a portfolio: delta, capital requirements, and return on capital. Let's discuss each.

Derived from an options-pricing model, delta is an estimate for the amount an options price changes when the underlying security moves up or down $1. While call options have delta between 0 and 1.00 and put options have delta from –1.00 to 0, a stock has delta equal to 1.00.

Delta can also be extended to an entire portfolio through beta weighting  on the thinkorswim^® trading platform. Beta weighting converts deltas of individual positions into beta-weighted deltas relative to a common unit—like the S&P 500^® index (SPX)—so an investor can look at the portfolio's risk compared to the overall market.

Like an investor, a trader looks at the total beta-weighted delta of their portfolio to assess overall risk. But they'll also go one step further and look at each position's delta to see if one is much bigger or smaller than the others. That could indicate excess risk in one security, which traders typically don't want.

Let's look at an example. Say, you have 300 shares each of various stocks. The deltas have been beta weighted to the SPX, which shows that, in SPX terms, FAHN has more deltas than GVRC. A trader might decrease the deltas in FAHN by selling some shares, buying a collar (buy a protective put, sell a covered call), or selling covered calls. Or they might increase the deltas in GVRC by buying shares or shorting puts.

Having relatively balanced beta-weighted deltas could help a trader diversify their positions and potentially reduce unsystematic risk, which is the risk associated with an individual holding rather than the risk stemming from exposure to the broader market. Because traders never know which trade could be the next loser, many avoid the risks of outsized positions. Investors probably don't want the risks associated with highly concentrated positions either.

To place a trade, a trader needs a certain amount of capital (i.e., money) in their account. How much capital they need depends on the trade(s) and type of account they hold. Some trades in certain underlying stocks have bigger capital requirements, and some have less. Explore how much capital an individual position requires on the trade's Position Statement located on the Monitor tab on the thinkorswim^® platform.

The BP Effect, or buying-power effect, is the impact a position has on an account's available trading capital or buying power (see image below). With some short options positions, the BP Effect is negative, and it's easy to see how much capital one position is using. If one position uses more capital than the others, reducing that stock's position, or hedging, can potentially bring the BP Effect more in line with the others. 

Making sure the capital requirements of positions are relatively equal helps provide insight into how much money is needed to increase an allocation into different assets or how much capital might free up by closing certain positions.

Return on capital is a way to think about how much a trade could potentially make relative to its capital requirements. Now, what a trade could "potentially" make is anyone's guess. For a realistic return on capital that doesn't depend on a stock's direction, consider something more quantifiable like theta, which is an estimate of how much an option might lose each day due to time decay. Short options positions typically benefit from time decay (positive theta), and long options lose value because of time decay (negative theta), all else being equal. Because time is constant, looking at return on capital based on theta can help traders balance positions with delta and capital requirements.

For example, say a trade that makes an estimated $10 of positive theta every day and requires $1,000 in capital has a lower return on capital than a trade making $10 of positive theta every day that requires only $500 of capital. Is it a perfect metric? No. But it lets us compare apples to apples, like beta-weighted delta. But unlike deltas, which need to be beta weighted before adding them together for the portfolio, theta of individual positions can be added together to get a total theta. (One day passing is the same for every position, and theta is expressed as an estimate for the dollar change in value, per one day passing.)

Now, capital's theta return doesn't mean additional cash is generated in the account. Here's how a trader might think about capital's theta return. They may prefer to earn a certain percentage of their capital—say 0.01%—from theta every day. That's $1 of theta for every $10,000 of capital requirement. If a short out-of-the-money (OTM) put position, for example, has a lower capital return than they'd like, the next step might be to consider the components of the calculation: theta and capital requirement. While the short put's theta can't be changed, turning the short put into a short put vertical can sometimes reduce the capital requirement. To build a short put vertical out of an existing short put, they need to buy a further OTM put. But which one?

The theta of each option appears on the Trade tab on the thinkorswim platform (see image below). After looking at the theta of the short put, some traders will look for a further OTM put with a small theta that won't reduce the positive theta of the short put too much but with a strike that isn't too far away from the short put's strike.

For example, if a trader is short a put that has $1.50 of positive daily theta and a capital requirement of $20,000, its theta return on capital is 0.008%. If the short put is converted to a short put vertical by purchasing a put that's 30 strikes further OTM and has a theta of $0.20, the resulting short put vertical will have a net theta of positive $1.30 ($1.50 – $0.20) and a capital requirement of about $3,000. By sacrificing some positive theta to reduce capital requirements, the position's theta return on capital increased to 0.0433%. Yes, the potential profit is smaller, but capital's theta return is higher.

If a trade is tying up capital, the goal of the trade could be to contribute to the portfolio in a positive way. Having a target theta return on capital tells a trader that each position is contributing its fair share. Say, the daily theta of your portfolio is $559, and the total capital requirement (BP Effect) is $358,296. The portfolio's theta return on capital is 0.156% per day. If that number is lower than the target, the trader might need to reduce capital requirements. If it's greater, they may need to reduce position size.

These three metrics—delta, capital requirements, and return on capital—can change daily. While traders might make daily adjustments to portfolios by entering new trades and closing existing trades, an investor might prefer to think of these metrics in terms of a range—from an acceptable low to an acceptable high. That way, daily metric changes can fluctuate but still remain within a desired range. But it's important to remember, position adjustments increase transaction fees.

Delta, capital requirements, and return on capital are all metrics available on the thinkorswim platform. Whatever a trader's preferences and trading style are, they can still allocate fixed percentages to different asset classes like stocks, bonds, and cash. Adding new criteria and evaluating stock and options positions in terms of these three metrics can often lend additional insight. And, although an investor may not make daily portfolio adjustments, checking a portfolio's metrics daily—like many traders often do—can be a worthwhile task.