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What is the difference between my style of trading and Amaranth? Hedging! We hedge our trades to avoid market meltdowns. Perhaps it is overly cautious at times, but today we had a great example of how a little hedging can go a long way in protecting a trade gone wrong.

After Wednesday's oil inventory report, we (the comment group) were positive oil was facing another leg down. Aside from my well-documented beliefs that oil is still overpriced and inventories are overflowing, we felt there was a strong disconnect between the actual price of crude and the price of the companies that sell it:

Notice how ExxonMobil Corp. (XOM), for example is outperforming the price of crude by 30%, while Suncor Energy Inc. (SU), Schlumberger Ltd. (SLB), and the Oil Service HOLDRs ETF (OIH) are up by 15%. Valero Energy Corp. (VLO) was the stock that most closely tracked crude but, since 9/25, it has veered away and is now 7.5% higher than crude in a month.

As you can see from a 1-year chart, until July ALL of these stocks tracked United States Oil Fund ETF (USO) (the oil ETF) very closely. For XOM in particular, Zman did an excellent analysis of why this situation is unlikely to continue.

This disconnect of the fundamentals made us think Thursday's action was unwarranted and we doubled down on the October oil bets that went the wrong way on us. This put me more in on the put side than I liked and, facing the close of Thursday with the Valero Rule telling us oil was going higher -- I decided it was a good time to hedge the bet...

People make fun of me because I get nervous and cover my positions when I have a "bad feeling" or see something that bothers me, but this is a great example of how being right once makes up for every single time I give up a small gain by being too cautious!

I was worried enough in Thursday's comments to cover all the oil puts with protective calls at 2:50 (really 2:42 due to bad Google clock). At the time I said:

"You can still buy United States Oil Fund ETF (USO) ($53.25) -- if oil is in such a rally it's a great opportunity to make a fortune on tomorrow's gap up. The buyer was paying over ask for 9 minutes like it was life or death -- what changed at 2:32??"

"And they jacked up the NYMEX close to $58.05 so they could avoid printing a $57 number..."

"Meanwhile I am back on protective calls with XOM ($67.50s for .85) and VLO ($52.50s for .90) as even though it's nonsense we have to protect against it."

So, when you can't fight the power, you go with the flow! That cover saved my week, as they both shot up today and, at 1:50 today I decided to roll out of the positions:

"I don't know about VLO hitting $55, I think I'm going to go for it, I have plenty of XOM $70s to cover a roll-out, and now I'm taking the VLO $57.50s for .20 of my $1 profits so I can dump out on a turn with no regrets. This gives me an almost free ride on my puts (down 25%), a lot better than it could have been!"

I called a top on oil (and boy do I hope I was right!) and sold my VLO $52.50s for $2.10 (up 133%) as well as my XOM $67.50s for $1.55 (up 82%).

I took a roll to the VLO $57.50s for .20 and the XOM $70s for .20, in case I was going to miss something, but the key is I made enough money to pay for my October mistakes (so far). At this point I am so relieved that I almost don't mind if they expire out of the money (I say that now but losses drive me crazy!).

So the cover play netted an 85% profit after subtracting the rolls, which reduced the cost of my remaining puts to just 15% of my original purchase. Obviously we will not be taking additional October positions, but as least we have a reasonable chance now of escaping the month with a profit!

To illustrate how powerful move covering is when it goes your way (and it often doesn't and you end up spending a lot of commissions and losing a nickel or two on each end), we'll review where we were vs. where we are now:

OIH $125 puts were already reduced to $2.75 from our 10/12 cover, and they traded all the way down to $1.40 today (- 49%). The cover reduced the basis to .45 and a 211% profit. Obviously we set a stop at .90 to preserve the double.

Public Service Enterprise Group Inc. (PEG) $60 puts had been doubled down to a $1.20 basis on 10/12, but that wasn't enough to stop today's carnage from bringing those puts down to .50 and a 58% loss. Even with the cover credit bringing the basis down to .50, it's still a disappointing play.

For those checking the math, this cover was made on the value of the puts at the time, not the original price -- this is always a judgment call you have to make!

VLO $50 puts were picked up at .90 and dropped all the way to .15 (down 83%). Of course this is why we covered VLO in particular, as it was a heavy put position with November puts as well. Even so, the basis is still a disappointing .15 (even).

Note: It is very effective to do quick covers on longer positions to ride out temporary uncertainty, as it becomes a current option with disaster insurance built in!

XOM was our other direct cover as we had a $67.50 put entries that had already taken hits and been doubled down for a $1.10 average entry. Those puts dropped to .45 (down 60%) but the cover reduced the basis to .20 (up 125%).

This is what insurance is supposed to do, cost you a little bit of money each time you buy it, but prevent you from experiencing a catastrophe!

We often talk about leaving options "naked" and you should be embarrassed to be caught that way. Much like the Amaranth trader who let it all hang out, sometimes the markets can turn on you and bite it off!

Read all of Phil Davis's articles on Seeking Alpha.

Source: Avoiding the Slick: Hedged Oil Positions