Hedging Options Gains After Hours – Case Study Mellanox Technologies

• Posted by Greg Harmon
• on July 19th, 2012

I had a nice conversation on twitter last night with a follower. It started as congratulations for being on the right side of an options trade in Mellanox Technologies, $MLNX. This person had purchased the July 80 Calls, which traded last at 55 cents, so they were in for a monstrous gain. I was jealous as my July 65/60 1×2 Put Spreads that I put on for a Quarter credit, were going to yield me just that Quarter. With the stock at 104, a 4,000% return could make anyone jealous. As we went back and forth though the stock was falling so I asked if they were hedging the gain by selling stock short in after hours. The reply was something like “I would never short this puppy, it is a great stock.” But I was not suggesting that they short the stock. Let me explain.

The chart above shows the after hours price action on $MLNX for the 60 minutes after the halt for earnings was lifted. A gap at 80 followed by a quick run up to 107 and then a bleed lower settling around 95.50 an hour later. What I was suggesting was a simple hedging technique to lock in the gains on the options without any overnight downside risk. By selling the stock short at 104, when we first spoke, the gains on the options are capped at $24, but they are also locked in. If the stock falls to 100 or 90 or 80 in the morning the options would be worth approximately $20 or $10 or nothing when the market opened at 9:30, but the the gains from the short sale from $104 would be worth $4 or $14 or $24 at those prices, locking in a net $24 on the trade. The hedge offsets the pullback in the Option value. So instead of watching the gain on this trade go from $24 down to $15.50, selling short to hedge would lock in that $24 gain. Unwinding the hedge is simple too. Just buy back the stock at the same time as selling the Call Options. This far into the money and with only 2 days to expiry the Call Option will have a delta in the high 90’s, meaning it will move nearly penny for penny with the stock. This can be used to hedge gains in puts as well. The hedge in that case is just buying the stock.

Think about using this technique the next time you have a big gain in options happen after hours.

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