Keeping it Simple: Taking Profits Versus Hedging Long Calls

As I mentioned previously, entering a calendar spread provides one way of protecting gains in a long call position which has appreciated. Under the right circumstances, this can work well as a hedge against a fall in the underlying entity, but sometimes it’s worth simply taking some profit and making some or all of the gains permanent.

Those SPDR S&P 500 (SPY) calls at 171 in the March 2014 series and PowerShares QQQ (QQQ) calls at 80 in the January 2014 series which were trading around $2.62 and $.38, respectively, back in April, had climbed significantly by June (“Calendar Spreads as a Follow-Up Strategy for Longer Term Call Buys”). The corresponding prices now are around $5.24 and $1.85, representing gains of 100% and around 385%, respectively. (Even for investors who didn’t buy these options until June, gains are still very healthy for a three-month exposure to the market.)

I’d originally suggested than an investor in the position of sitting on large gains in a long call position such as these could consider the calendar spread as a worthwhile way of protecting some of those gains. The strategy can be particularly attractive for investors who would like to take advantage of pullbacks in the underlying by closing the shorter term, short side of the spread.

As the time to expiry decreases, however, it may become preferable simply to close a portion of the position rather than attempting to hedge by writing shorter term calls to create a calendar spread.

Particularly in the case of the QQQ calls, being three months closer to expiry than we were back in June means that nearly half the time to expiry has passed. This makes calendar spreads less attractive and, for those already sitting on large gains in the options, brings the risk of giving up a significant chunk of the profit that much closer.

I have no idea whether it will ultimately prove better to keep positions like these entirely intact and ride them to even larger gains in the future. But as with my suggestion in July about protecting gains in Apple from overreactions (“Avoiding an Apple Overreaction”), investors don’t need to know what will ultimately happen, provided they’re using suitably structured positions and taking profits when it’s prudent to do so.

• QQQ
• SPY