3 Wise Ways to Hedge with Options

01/13/2012 7:00 am EST

Focus: OPTIONS

Choosing from these hedging methods will allow traders and investors to secure effective protection for existing positions—in some cases at little or no cost.

Hedging is when you take a position in order to protect against losses in some other position. Rather than put all your eggs in one basket, you put some in one basket and some in another basket that is inversely correlated to the first.

If you are long a certain stock, you might choose to hedge that position by buying some put options for the same stock. That way, if the stock drops, you are protected somewhat. You can exercise your puts and receive the strike price per share as a floor price for your investment.

See related: Proven Ways to Hedge with Options

Sounds Good…What’s the Catch?

The catch is that hedging is not free. Much like buying insurance, there is a cost associated with hedging (or removing risk) from a position. The cost you pay to buy the put options, for example, is not zero. If the stock stays flat or rises, then you have lost the option premium you paid for those puts.

A Cost-Free Option Hedging Technique

Option hedging techniques range from total protection (buy an at-the-money put—very expensive) to no protection (no hedge). In between are two common partial hedges: (1) buy out-of-the-money puts or (2) sell calls.

Buying put options is a simple enough strategy, but the costs are often high. Selling call options is a way to generate some income and at the same time get a little bit of a hedge because of the premium you receive. It’s not as much of a hedge as buying put options, but it’s also cost-free. In fact, you can actually come out ahead in many cases since selling calls is income producing.

See related: Using Options for Portfolio Insurance

Example 1: No Hedge; Just Buy and Hope (Hold)

You buy 100 shares of XYZ at $52.50/share and hold for four months. Maybe you make some money; maybe you lose some money. It’s an unhedged long position and could go either way. If it’s a high-Beta (i.e. volatile) stock, has earnings coming out, or if your position is too big for your portfolio, then you may not sleep well with unhedged exposure.

Example 2: Hedging By Buying a Put Option

Same stock purchase, but this time you also buy one put option with a strike of $45 and pay $2 (per share) for four months of protection. You know that no matter what happens you can get at least $45/share for your stock between today and option expiration.

If on expiration day, XYZ is higher than $45, you keep your stock and the put option expires worthless. You’ve lost $2/share on the option but have had the peace of mind that no matter what happened over those four months, you would always be able to sell your stock for $45/share if you so desired.

Example 3: Hedging By Selling a Call Option

Same stock purchase, but you do a weaker form of hedging by selling one call option with a strike of $60 that is good for four months. You receive $2 (per share) for selling the option. Now, your downside case has gotten potentially worse; if XYZ drops through the floor, you will realize the entire loss except for the first $2 (per share).

On the other hand, if XYZ does not drop significantly, and if it stays below $60 by expiration day, then upon expiration, the option will expire worthless and you will have made $2/share on the option trade.

The stock may have gone up or down during that time, so it’s not easy to say whether you’ve made money overall or not. But you can now sell another call option for the next three to four months and earn another batch of income.

If XYZ is trading above $60 on expiration day, then you will be forced to sell your shares for $60/share, so you made $7.50/share on the stock and $2/share on the option for a total max profit of $9.50/share (which is 18% in four months).

NEXT: Which Form of Hedging Is Best?

|pagebreak|

So Which Form of Option Hedging Is Best?

It depends on your risk tolerance level and how much profit you are willing to give up in order to limit your losses.

Buying puts will guarantee you a floor price for your stock, but will eat into your profits and might be expensive. Selling calls will generate income and give you some protection, but it also creates a cap on your upside. If you do sell covered calls and set the strike price to a level you’d be happy selling your stock for, then it’s a pretty good plan.

See related: 3 Ways to Profit from Covered Calls

You don’t have total downside protection with covered calls, but you have to ask yourself, if you are so worried about the stock’s downside, then should you even buy it? Maybe sell it and buy something for which you’re not as worried about the downside case, and then sell calls against that new stock.

Real World Examples

Here are a few stocks selling at or near their 52-week highs, which makes them reasonable candidates for at-the-money or slightly out-of-the-money covered calls if they are in your portfolio.

None of these Jan 21 options have earnings releases before expiration. There’s not a ton of downside protection here, but perhaps a way to get a little extra gain in the two weeks before expiration. (Be sure to check current pricing, as this list was developed a few days ago.)

The stocks are Liz Claiborne, Inc. (LIZ), Apple, Inc. (AAPL), Atlas Pipeline (APL), and Nike, Inc. (NKE).

chart
Click to Enlarge

By Mike Scanlin of BornToSell.com

Related Articles on OPTIONS