Current Issue

April 02, 2008
Hedging With Options

Hedging with Options

Did you hold your tech stocks last month hoping for an upside bounce? YES! Are you now wishing you had sold instead? YES! Well, now you can reap the benefits of both.

Here's how...

Portfolio insurance is nothing new to professional traders yet unknown to most retail investors. Before you say, "I don't need any insurance," think about this: Many investors' homes and cars are insured, yet valued less than their stock portfolio. In addition, we have recently seen some of the bluest of blue-chips such as Proctor and Gamble, Home Depot, Eli Lilly and Hewlett-Packard lose over twenty-five percent of their value in a single day. Don't think it can't happen to the tech stocks you hold. If you are not familiar with portfolio insurance, read on and find out how the professionals take the emotions out of investing.

 

It is often said that knowing when to sell is the most difficult part of investing. This is because of the two most significant factors that drive the markets: greed and fear. When stocks are flying, we hang on hoping for more. When they fall, we sell the shares out of fear, often forgetting about the long-term reasons we bought them in the first place. We are afraid to take profits yet quick to take losses, which is not a very good formula for making money in the markets!

 

Read on....

Earn $2,000 Each Month with a Conservative Options Strategy

We will show you how you can make $2,000 in cash each month using your existing portfolio equity as collateral. This low-risk strategy works no matter which direction the market goes. Best of all, it is easy to implement and no previous experience with options is necessary.

Take a complimentary 30 day test drive.

Click Here: http://www.optioninvestor.com/newsletters/mcm.aspx?aid=18

 

Now, we are not advocating short-term trading. After all, the stock market has a very long history of an upward bias, and statistically speaking, you are better off buying and holding. But the emotional side of the investor rarely allows this strategy to work. The roller coaster starts, your profits become losses, and there you are selling at a loss again. Is there a better way to trade?

In certain circumstances, you may want to consider portfolio insurance. Basically, portfolio insurance can be defined as an added asset to your portfolio that will increase in value as a particular stock or index falls in value. Financial professionals call this a hedge, and we will look at many ways to place a hedge in your portfolio, some without any out-of-pocket expense!

To understand hedging, you need to understand some basics of the options markets, as this is one of the primary tools used for hedging. Options were created as a way for investors to buy and sell risk, and while this may seem unusual, it actually occurs in many ways in our everyday lives. For example, driving a car involves the risk of wrecks, injury, and theft. You do not want this risk, but for a fee, your auto insurance company does. You have, in fact, transferred the risk to them. When you buy a one-year magazine subscription, you are transferring risk. The magazine company is at risk if the price of its magazines goes way up. Of course, you are at risk if the price stays the same or falls. But for the up-front fee, you both consider the risks mutually beneficial. Out of economic necessity, the options markets were created in 1973 as a standardized way for the financial markets to transfer risk.

In most cases, options can be purchased through most brokerage firms with just as much ease as a stock. Usually, you will need to fill out an options application and wait a few days to get approval. Do not worry if you do not get approved or are not comfortable with options, as we have another way for you to hedge yourself that will be discussed later.

More about options

What exactly is an option? Options are assets that give owners the right, but not the obligation, to buy or sell certain securities (or indexes) at a fixed price over a given amount of time. Since the owner has the "right, but not the obligation," this means that the owner of an option chooses whether or not to buy or sell -- it is their option to do so, hence the name.

There are two basic types of options; calls and puts. Call options give the owner the right to buy the stock (or "call" it away from the owner), while put options give the owner the right to sell the stock (or "put" it back to the seller). This is a contractual obligation, controlled through a clearing firm (called the Options Clearing Corp. or OCC), so there is no need to worry about a defaulting party on the other side of the transaction. Because they are contractual obligations, options are traded in units called contracts, just as stock is traded in shares, with one contract usually representing 100 shares of stock.

Options are standardized meaning there are only certain prices at which you can agree to buy/sell stock as well as specific time frames. The prices are set by the exchange at fixed intervals and are known as strikes, because that is the price where the contract is struck. As for the time frames, you will always find at least four different months being traded for stock options. There will always be the current month, the following month, and at least two additional months. Also, there may be longer-term options that can go as long as three years. Options do have a specified expiration date which, for trading purposes, is the third Friday of the month.

That's a lot of information, so an example should make things clear. Let's say it is October and you are bullish on XYZ stock trading at $50. You could purchase a January $50 call option that gives you the right, but not the obligation, to purchase XYZ for a price of $50 through expiration in January. Now, of course, there is a fee for this, called the premium, and let's say it is $5. This means that you are paying $5 per share, but remember, each contract controls 100 shares so the total purchase price for one contract would be $500 plus commissions. Now, you have the right to buy the stock at $50 per share at any time through expiration. If XYZ is trading for $70 when the option expires, the call option must be worth $20 (the difference between the stock price and strike). However, if XYZ is trading at $70 before expiration, then the option will be worth at least $20 as there will still be time remaining on the option and investors are willing to pay for time. How much they pay is up to the market and determined solely by supply and demand for the option. Of course, if the stock closes below $50, the option expires worthless so the most you can lose is the amount paid, in this case, $500.

You may be thinking, "Hey, wait a minute, how do I know the market makers won't try to rip me off and only offer me $15 for the call when I decide to sell?"

If XYZ is trading at $70 and the market makers are bidding $15 for the $50 call, then the arbitrageurs will step in and come to your rescue! These are people who watch for price discrepancies in the market and are able to make riskless transactions for guaranteed profits. These transactions happen at lightning speeds and do not last for long. Arbitrageurs will buy the call for $15, sell short the stock, and receive $70 for a net credit of $55. They will then exercise the option (use it to buy stock) for $50 and keep the $5 profit -- exactly the amount the market maker, in this example, was trying to steal! This process will continue until it disappears, at which point, the option will be trading for $20. So have no fear, the market makers cannot steal the intrinsic value (the difference between the stock and strike) of your option!

What if you were bearish on XYZ? Well, you could instead buy a January $50 put. Now you have the right, but not the obligation, to sell your stock for $50 per share through expiration in January. If XYZ is trading for $40 at option expiration, the put must be worth $10 (the difference between the strike and the stock price). If XYZ is trading at $40 before expiration, the put must be worth at least $10, as there will still be time remaining. If a market maker decided to only bid $8 for the put, arbitrageurs will buy the put for $8, buy the stock for $40 (far a net debit of $48), exercise the put and sell the stock for $50 for a guaranteed profit of $2. Again, this process (which would be measured in seconds) will continue until the put is priced fairly at $10.

So far, we have only considered the owners or buyers of calls and puts. What about the person who sold them? Well, the seller of any option has an obligation to perform. If you sell a call, you must sell your stock if and when the owner of the call chooses to buy it. If you sell a put, you must buy the stock if and when the owner of the put chooses to sell it. It is only the owner (the long position) who has the right; the seller (short position) has an obligation.

Hedging your portfolio

Now that you have the basics of options, let's look at ways to hedge and see if hedging sounds like a good idea to you!

Assume we are back in late May and you bought Intel (INTC) at $55. Later, in mid July it's trading above $70 and you decide to hedge by buying a January $70 put trading for $10.

By placing this trade, you have guaranteed yourself a profit of at least $5 per share through expiration in January. This is because you can always sell your shares for $70 but it cost you $10 for a net of $60. Because you paid $55 for the stock, the put guarantees you $5 per share profit.

Now consider the advantages of this trade. If the stock continues to move higher, we still participate in the upside (less our $10 premium). But if the stock starts to fall, as it did in mid-July when we bought our put (see chart above), we now have removed the emotional side out from our trading! The put allows us to focus on fundamental values in the company, and not the short-term downtrend. We can hold the stock, hoping for an upturn, yet never regret it as we have locked in a profit. There's also no fear of a maintenance call (for those who trade on margin). Best of all, it's easy to sleep at night knowing you never have to look back thinking "I should have sold that back when it was $70" because now you have the option to do so! It's not a bad deal if you think about it -- guaranteed profit of at least $5, with no limit to the upside, and we have all the way until January reap our rewards.

Some people think the "downside" to this trade is if the stock continues to run higher and you "wasted" your $10 on the put. However, is your home insurance a waste just because it never caught fire? Of course not, and you shouldn't feel that way about the put either. In fact, because you still participate in all of the upside movement of the stock, the best thing to happen is for the stock to climb higher, leaving your put worthless.

Let's look at our profit and loss profile (at option expiration) on the trade above with and without the put.

Stock Price	Profit/Loss for long stock @ $55	Profit/Loss for long stock @ $55 + long $70 put @ $10
100	+ $45	+ $35
90	+ $35	+ $25
80	+ $25	+ $15
70	+ $15	+ $5
60	+ $5	+ $5
50	- $5	+ $5
40	- $15	+ $5
30	- $25	+ $5

It is easy to see the value of the protection here. Look at the profit/loss for the two positions in the table above. If the stock closes at $100, the long stock position will have a gain of $45 points ($100 minus the $55 cost), while the long stock/long put position will have a gain of $35 (this is due to the $10 spent on the put). There will always be a $10 difference between the two positions for all stock prices at $70 or above. So the investor that hedged the portfolio will only be off by $10 in terms of profit and loss to the upside, but look at the difference to the downside!

For any stock price below $60, the hedged portfolio dominates. For example, say the stock closes at $40. The investor who bought the shares at $55 is down $15 points. The investor who hedged is also down $15 on the stock but the $70 put must be worth at least $30 points (the difference between the strike and the stock price). This gives a profit of $15; however, we must subtract out the $10 cost of the put, which gives us a total profit of $5. This $5 profit will hold for all stock prices below the $70 strike of the put. This is exactly what happens in a fully hedged position. The loss on the stock is exactly offset by the gain in the option.

Options can be very versatile and there is no need to necessarily have hedged our imaginary position above at $70. If you are willing to take a $5 point "deductible," you could have elected to purchase a $65 put which would be cheaper than the $70 for exactly the same reason your auto insurance is cheaper when you assume some of the risk through a deductible. The options market will always give less value to a put with a lower strike with all other factors being the same. So the choice is yours...do you want more protection or cheaper cost?

Hedging with no out-of-pocket expense

There is another hedging technique that may be interesting to you. This one allows you to hedge all the downside risk, as above, but without paying for it! Of course, nothing is free in the financial markets, so what's the catch? The catch is that you must be willing to give up some or all of your upside potential in the stock. We do this by selling call options against the stock and then using that money to buy the puts. Remember that when we sell an option we have an obligation. So if the person who buys the call from us elects to buy our shares, we must sell. This hedging strategy is sometimes called a collar.

Let's run through an example with the same INTC trade above. Again, we bought shares at $55 and the stock is now $70. The $70 put is trading for $10. We could sell the $75 call option and buy the $70 put. Depending on where they are trading, this trade may result in only a slight debit instead of the $10 we paid before. Or we could buy the $65 put and sell the $75 call for a credit of about one. That's right, depending on which options we choose, we can actually get paid to put on the hedge. But be careful, the only way to get a credit is to allow for a bigger downside loss. It doesn't mean that it's necessarily a bad trade, it's just that the credit doesn't come for free.

For example, say we sell the $75 call and buy the $65 put for a net credit of $1. This means we actually get paid $100 per contract. Now, what does the profit and loss look like at option expiration?

Stock Price	Profit/Loss for long stock @ $55	Profit/Loss for long stock @ $55 + long $65 put + short $75 call for credit of $1
100	+ $45	+ $21
90	+ $35	+ $21
80	+ $25	+ $21
70	+ $15	+ $16
60	+ $5	+ $11
50	- $5	+ $11
40	- $15	+ $11
30	- $25	+ $11

Now compare this profit/loss (at expiration) table to the previous one. We can easily see that we have sacrificed upside potential, as our max gain with the collar is only $21 regardless of how high the stock goes. However, because we didn't pay $10 for the put, our downside is much higher with a credit of $11 instead of $5.

To recap, hedging is a method of maintaining upside potential, whether limited or unlimited, and reducing our downside loss. Hopefully, it is now apparent that hedging can be beneficial!

Hedging without options

There is a really nice way to hedge your portfolio without the use of options. Through the use of "bear" mutual funds, mutual funds that go up in price as the market falls, one can easily hedge a portfolio. However, some funds are better than others for hedging. One that we like to utilize from time to time is the ProFunds UltraShort OTC Fund (USPIX). This fund is unique in that it produces double the inverse of the Nasdaq 100 (NDX), the most volatile of all indices. So if the NDX is down 5%, this fund will be up 10%. Of course, the reverse is true too; if the NDX is up 5%, the fund will be down 10%. Further benefits are that you are not on margin, as would normally be the case to produce a 2:1 performance ratio. Also, you do not need options approval and there is no expiration as with options. You are also not exposed to "time decay" which is the portion of the option premium that erodes with the passage of time. On the downside, mutual funds only trade at one time -- in the evening after the close -- so you cannot trade them intra-day. But if you have a heavily laden tech portfolio and are looking for a relatively cheap way to hedge, USPIX is tough to beat!

These are just the basics of options and hedging, and are intended to show the benefits of hedging, which can be very important at certain times in the market.

Please understand that these are just the basics; there are numerous factors to consider before placing a hedge. Some of the factors are the deltas and gammas (options sensitivity measures) as well as implied and historical volatilities.

Remember, in a bear market, the money returns to its rightful owner. Hedging can keep you from giving it back!

 

 

####

Disclaimer

RightSide Holdings/21st Century Investor Education/RightSide Advisors,Inc is neither a registered Investment Advisor nor a Broker/Dealer. Readers are advised that all information is issued solely for informational purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy, nor is it to be construed as a recommendation to buy, hold or sell (short or otherwise) any security. All opinions, analyses and information included herein are based on sources believed to be reliable and written in good faith, but no representation or warranty of any kind, expressed or implied, is made including but not limited to any representation or warranty concerning accuracy, completeness, correctness, timeliness or appropriateness. In addition, we do not necessarily update such opinions, analysis or information. Owners, employees and writers may have long or short positions in the securities that are discussed.

Readers are urged to consult with their own independent financial advisors with respect to any investment. All information contained in this report and website should be independently verified.