How to Handle the Volatility With Options

For example, if you bought the first third of the XLF position at $30 a share yesterday morning, to fully hedge it you'd need to buy around nine $28 puts. As the stock traded down to $29 and you bought another 333 shares, you'd need to buy an additional seven puts. Finally, at $28 a share, you'd need to buy a final four contracts to be fully hedged.

I'd rather go in and buy around 15-20 puts right off the bat, when I make the first purchase. Why? I assume I'll buy more stock at lower prices. By getting myself fully hedged from the beginning, the initial cost of the downside protection will be only marginally higher than the total cost of using a scale. Remember, as shares of XLF decline, the price of the puts will go up.

This leads to the important point that by purchasing the full slug of puts from the beginning, you're creating a position that is long gamma -- the position gets longer as shares rise, and actually gets shorter or more bearish as price declines -- meaning you can profit even if the share price of the equity you're involved with keeps declining.

I recently expanded on how to define your risk profile and provided some resources for making adjustments and capitalizing on the opportunities presented during periods of increased volatility.

Use Spreads to Control Exposure

There are a lot of equations involved in figuring out the value of options, and it's important to be able to understand and distinguish each one's meaning and impact price. One example is that the terms "volatility" and "vega" are often loosely used interchangeably.