Well of course nobody actually wants to buy garbage.  But I believe I can make a potential case for doing such a thing. 

Let’s start by describing exactly what I’m talking about.  I consider “garbage” to be an option that is very far out of the money with a very near term expiration.  I typically do a lot of trading with SPY.  So I like to consider single leg options “garbage” when they are 1-3 days from expiration and only cost a couple of pennies.  I also consider a vertical spread “garbage” when it is 1-3 days from expiration and only costs a couple of pennies (preferably 1 penny) or so. 

The reason such trades are called garbage is that you are likely throwing away money when you would make such a trade.  Let’s face it, if you buy an option or a vertical spread with that type of scenario, you are very likely to lose money.  However, there is a hope here.  The hope is that I actually want to lose money on the trade.

In case you haven’t guessed it by now, allow me to explain….this is a hedge.  With that in mind, what are we hedging.

First off, as a registered advisor, I’m not allowed to give specific strike prices to the general public.  So, for this example, we will simply use my all-time favorite underlying…XYZ.

Let’s say that you are “bullish/neutral” on XYZ stock.  So, you decide to sell a bull put credit spread.  You believe that the stock will stay above 50 between right now and expiration, but not necessarily increase that much.

XYZ price:  55/share

Sell:  45/50 put spread for a $.50 credit

This is a classic trade and there is not much to it for an advanced option trader.  However, what I want to address here is the debate that has plagued credit spreaders for decades.  That is….how do I manage this risk?

While there is no shortage of information out there on how to manage risk, I want to share a way that I’ve been using lately….I have been buying garbage.

If I am short a 1-month put spread, one of the strategies that I like to use (this isn’t the only thing I do and you should be versed in other methods as well) is to buy a 50/45 put spread for the weekend.  I typically use only a half position, so if I’m short 2 1-month spreads, I will only buy 1 weekend put spread.

First off, why the weekend?  Well, on weekends, bad things can happen that I cannot control.  Yes, bad things can happen at any time, but between Friday at 3pm Chicago time and Monday at 8:30am Chicago time, option markets aren’t open.  That is a long gap.  During the week, there is only an overnight gap (I’m talking about stocks, not futures).  So, if I buy a garbage put spread for the weekend, I’m hedged for approximately 72 hours (from Friday’s close to Monday’s close).  Those 72 hours account for roughly 40% of the 7 day week.  That makes me feel very comfortable. 

Do the prices match up?  The answer to that is a definite maybe.  If I’m going to receive a decent credit over the course of a month (or possibly more), I want to be in a spread where I can buy a weekend spread for a penny or so if I’m using this strategy (once again, I do NOT do this every time I sell a put spread).  For certain stocks and time frames, this will work, and others, it will not.  For example, I’m currently short a put spread where I received .40 for 4 weeks.  If I pay a half a penny every weekend (remember, I only use half positions for this hedge), I will have .02 less in profits.  I’m fine with that for the ability to sleep over the weekend.

Why only a half position on the hedge?  This is a hedge, not a guaranteed way to save money.  I say that because that if markets do crash over the weekend, you will still lose money doing this (most likely).  However, you will likely lose much less of it, even with a half position hedge.  I prefer a half position hedge because I want to walk the fine line of being prudent, but not overpaying for price insurance.

If you have any questions on this strategy or anything that I do as a financial advisor, feel free to email me at mtosaw@stcharleswealth.com.