SlingshotHedge

Theres Hedging & Theres HEDGING!

INTRODUCTION
There is a new hedge in town that is rapidly gaining in popularity. What other hedge can
you put on for a credit (putting money into your account / time on your side) and still
participate if a wild bull market ensues? The ever-popular collar (long stock, long
protective put and short a higher strike call to pay for the put) cannot do it, it has limited
upside potential (acts like a bull vertical spread). A covered write cant do it (acts like a
naked short put). There is not much upside and it is not even a hedge. A married put
(acts like a naked long call) gives you the upside but fails in the credit department
because it costs money. I would like to introduce to you a hedging strategy called the
SlingshotHedge, from a theoretical and practical point of view.
For whom is the slingshot engineered?
It can be appropriate if you own stock that you do not really want to sell (for tax reasons
or otherwise), and you are sick of collaring (selling a covered call to finance a put
purchase against your stock), and you continue to lose on the way down (albeit less than
if you had no hedge). What if your lousy stock finally does decide to take off? Your
upside potential would be capped off with a collar because of the short call(s) component.
Thats ok for short-term speculation but what about doing that with some of your core
holdings?
For example, one thinkorswim client who I recently talked to, has over 30,000
shares of a stock that has gone to 13 from 80. It has traded as low as 11. The last thing
this guy wants to do is to the traditional collar such as buying 300 of the 12.5 puts and
selling 300 of the 15 calls to finance the purchase of the puts. A collar-hedge will merely
cap-off his upside to 15. No Thank You!
Many investors long for the return of the market of the late 90s but find it difficult
to hang in there. When the market comes back, we all want to participate and not just
with a limited gain bull spread that collared stock emulates. We would all love to have
the protective quality of puts to minimize our downside. The slingshot is a versatile
strategy that can be employed using a myriad of ratios along with embedded calendar
spreads to further enhance strategy selection. Depending on the slingshot ratio, you will
not profit in a market rally as much as you would with naked long stock, but you will still
participate in the corresponding up-move. If the underlying stock doubled, naked stock
would make 100% profit from its current trading level. By comparison, the slingshot, on
the same move will generate approximately 50% to 75% depending on the position
configuration. Thats not bad considering that your stock could get clobbered on the
downside while the slingshot limits the loss to a tiny fraction, comparatively.
For classes specializing in the SlingshotHedge and other options related topics
contact TradeSecrets, the folks who know their options, at www.tsfn.com,
Is the Slingshot suitable for you?
The slingshot hedge strategy is clearly NOT for everyone and is most helpful if you have
an advanced understanding of synthetics and other relationships of option strategies. It is

2002 Charles M. Cottle

charles@thinkorswim.com

SlingshotHedge

also NOT for you if you do not have the other necessary resources: time and money.
You need a bit of time to analyze/monitor the position to make adjustments required or
desired, perhaps as often as two to three times a week or more. Some investors dont
spend or want to spend a lot of time managing their investments to this extent. I find that
a great many of the thinkorswim clients are sophisticated investors, who have been
beaten to death by the markets, and want to take control of what is left of their liquid
assets. Managing a slingshot is relatively simple and the position is not very convoluted,
providing that the ratio is small. The steeper the ratio, the more time and energy you
must devote to the endeavor.
How much time must be spent managing a SlingshotHedge?
Once an initial SlingshotHedge is put on an investor can wait until the end of the
cycle to roll the whole position to the next expiration or skip to the next expiration
month. It can even be done with LEAPS. In the meantime you may wish to take
advantage of market created opportunities and make trades that adjust the delta by rolling
positions between strikes (vertical spreads and butterflies) or months (calendar spreads)
or by using gamma scalping1 techniques to adjust deltas from time to time.
What size account can enjoy the slingshot?
Even with an existing portfolio of stocks it is recommended that additional capital equal
to 40% of the portfolio be on hand for margin, eventual margin, repair strategies and for
further adjustments desired (thinkorswims asset managers, keep cash reserves of 40%
deploying these strategies). Certainly having a portfolio of stocks enjoys the benefit of
option buying power up to 50% of the stocks net liquidating value. For example, to
hedge 1oo shares of Microsoft (currently priced at 50.00), you will have $2500 in option
buying power but it would be nicer to have the extra $2000 (40% of $5000) besides the
1oo shares. The same play can be made with $5000 buying stock on margin (including
the 40% reserve).
Keep in mind that without stock and a protective put, a long call may be used
instead (strike where the put would be bought for protection). This will require only
about $2220, $220 for the options involved and the extra $2000 for all the reasons
mentioned above.
ACTUAL STRUCTURE
For every 1oo shares of stock, buy one put just out-of-the-money to button up the risk to
the downside. Next: sell two out-of-the-money call vertical spreads and depending on
how much time there is to go and implied volatility levels you should generate enough of
a credit to pay for the put you just bought. With the sale of two verticals the risk is pretty
straightforward and easy to manage, you can even ignore the position for quite a while
(barring any major moves in either direction). Generally speaking, you will not be
assigned on your short call(s) until expiration unless there is a dividend being paid and
even then the stock has to be in-the-money enough for the put of the same strike to be
bought for less than the dividend amount2.
1
2

Gamma scalping can be studied in Coulda Woulda Shoulda Chapter 4 pages 85-94
Dividend and Exercise nuances can be studied in Coulda Woulda Shoulda Chapter 3 pages 62-76

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You may consider carrying extra short or long deltas according to your short-term
market opinion by increasing or decreasing the quantity of short vertical spreads.
To the downside, potential loss is tightly defined. To the upside the bear spreads,
whether one spread per 1oo shares or five, eventually stop losing while the stock has a
chance to go on to victory. There will be plenty of rolling opportunities to capture more
favorable risk / reward relationships for profit enhancement or to minimize loss. The
worst place for the stock to be by expiration, assuming absolutely no adjustments during
the cycle, is at the long strike of the short call verticals (top strike of the whole package).
Exhibit 1 shows the profit and loss profile for the current day identified by the
curved light colored line and the expiration profile using the straight darker line.
EXHIBIT 1
Slingshot (2 verticals to 1) Today (44 Days to Go) as Depicted in the thinkorswim Analyzer: Delta = 225, Theta = -3.

On this ratio, short 20 vertical call spreads for each 10 units long (meaning 10oo
shares and 10 married puts as protection), the position is still delta long with fairly neutral
time decay. The position behaves like, and is synthetically equivalent to 10 long
50/55/60 butterfly spreads plus 10 long 60 calls. The position works best if the market
sky-rockets but will definitely like the market to grind its way to 55 allowing the 10 long

2002 Charles M. Cottle

charles@thinkorswim.com

SlingshotHedge

50/55/60 butterflies to max-out at $5.00. The trade is employed, in this example, for a 75
cent credit, selling 2 call vertical spreads (each for a 1.00 credit, totaling 2.00 credit) for
each 1 put purchased (1.25 debit) and assumes that the stock is already long.
It should be noted that the whole package is valued at a synthetic or equivalent
debit of 2.00 ($2000 for all 10 spreads). This value is derived by first establishing a
synthetic call price of 4.00, the in-the-money amount of 2.50 (current stock price of 52.50
less the strike price of 50) plus the extrinsic value of the put being 1.25 plus 25 cents, the
cost of carrying a $50 for 44 days at 4%3. Take this 4.00 call price and subtract 2.00 that
is the credit for 2 call verticals each sold for 1.00 and you have the amount that will be
lost (provided no other adjusting trades) if the stock is trading below $50 by expiration.
DELTA NEUTRAL ANYONE?
This next ratio (Exhibit 2) is a bit more complicated and therefore requires a bit more
management. In a nutshell, it is selling 30 verticals instead of 20, as in the previous
example. It provides for a bigger credit (less of a synthetic debit), leaving you less long
(in this case).
The position behaves like and is synthetically equivalent to 10 long 50/55/60
butterfly spreads plus 10 short 55/60/65 plus 10 long 65 calls. In Exhibit 2, the darker
colored, straight lines show the expiration shaped risk profile of this slingshot and you
can pretty much see where the long and short butterflies as well as the long 65 calls come
into play.
On this ratio, short 30 vertical call spreads for each 10 unit long the position is
close to delta neutral with positive time decay and therefore currently has a market bias
desiring a small trading range. The position works best if the market sky-rockets but will
definitely like the market to grind its way to the 10 long 50/55/60 butterflies allowing
them to max-out at 5.00 while leaving the 10 short 55/60/65 butterflies in the dust
(worthless). Obviously the underlying price of 60 is the price that the position most
needs to stay away from. This particular ratio is done for a 1.75 credit, selling 3 call
vertical spreads (each for a 1.00 credit, totaling 3.00 credit) for each 1 put purchased
(1.25 debit), assuming the stock is already long and this individual is applying the options
to complete the SlingshotHedge. This ratio requires creative rolling and more active
management over time and price change.

Equation from Coulda Woulda Shoulda Chapter 8, page 163. Interest built into the 50 call 25 cents.

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EXHIBIT 2
Slingshot (3 verticals to 1) Today (44 Days to Go) as Depicted in the thinkorswim Analyzer: Delta = 0, Theta = +7.

2002 Charles M. Cottle

charles@thinkorswim.com

SlingshotHedge

HOW ABOUT A PLAY IN EITHER DIRECTION?

Simply buy twice as many puts 20 instead of 10 when you sell twice as many (20) short
verticals. It acts like 10 long 50/55/60 and long 20 * 50 put / 60 call strangles.
EXHIBIT 3
Double Slingshot as Depicted in the thinkorswim Analyzer

CONCLUSION
A slingshot acts like a butterfly with extra long calls as in Exhibit 1 and can be put on
without the use of stock; first long calls and then short twice as many short call spreads
above. Or you may enter a short call credit spread and subsequently purchase half as
many calls at the next strike down.
For a downside bias, a slingshot can take on the form of a butterfly with extra puts
that would be a mirror image of Exhibit 1 (mirror on either side, not top or bottom). You
purchase a put and also sell a put credit spread below. Dont forget that you can opt for
your long options to be in a deferred month to add the attributes of imbedded long
calendar spreads increased theta (positive time decay) in the position.

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