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Hedging With Options

The document discusses how options can be used to hedge investments and protect portfolio positions. Options are derivatives that give the holder the right to buy or sell the underlying security at a fixed price. The document provides examples of how buying protective puts, writing covered calls, and creating an equity collar can provide downside protection for stock holdings.

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198 views

Hedging With Options

The document discusses how options can be used to hedge investments and protect portfolio positions. Options are derivatives that give the holder the right to buy or sell the underlying security at a fixed price. The document provides examples of how buying protective puts, writing covered calls, and creating an equity collar can provide downside protection for stock holdings.

Uploaded by

boletodon
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Hedging with options

Can what is regarded as a high-risk class of investments actually provide protection for a
conservative investment portfolio? Yes, and once you know a little about exchange-traded
equity options, youll see how.

The basics

Strictly speaking, options are derivatives, their value deriving from the performance of an
underlying security. Options traded on U.S. exchanges give their holders the right, but not
the obligation, to buy or sell 100 shares of stock at a fixed strike price at any time up to
their expiration date. An option to buy is known as a call; an option to sell is a put.
Options can provide investors with leveragethe opportunity to magnify the effect of
an investment. A call on 100 shares of XYZ Company can be purchased for much less than
the actual shares. But if the price of XYZ rises above the strike price, the option holder can
cash in either of two ways: He or she can exercise the option, forcing a seller (called an
option writer) to deliver the stock at the strike price, and then can realize a profit by selling
at the market price. Or the XYZ call itself, which then would be in the money, can be sold
at a profit. However, if the price of the stock doesnt rise above the strike price before the
expiration date, the option will expire worthless.
Options also can provide the means for betting against a stock. Buying a put, an investor
is able to sell the underlying stock at the exercise price, no matter how low the market price
drops. Again, if the price does not drop, the option expires worthless.
Thus, buying an option may be regarded as a very risky investment, with the entire
amount of the investment subject to loss if the stock price does not move as anticipated. It
may be possible, however, to sell the option at a loss prior to expiration to close out the
investment.
Option writers, on the other hand, take on potentially larger risks in return for the
premium that they receive upon writing the option. Put writers obligate themselves to buy the
underlying stock at the exercise price, whatever its market value, opening themselves to large
potential losses. Likewise, those who write naked callswithout holding the underlying
stockcan obligate themselves to buy the stock at any price in order to deliver it to the call
holder at the exercise price.
Options as insurance

The leveraging uses of options are for experienced investors well-versed in sophisticated
strategies, and aware of and financially prepared to assume the attendant risks. However
there are some relatively simple options strategies that a conservative investor can use to
protect portfolio positions.

Buying protective puts. Suppose that you have a stock holding that has appreciated, and
you want to protect your profits should the market turn against you. You could set a floor on
the stock price by purchasing a put.
Say, for example, you had bought 100 shares of XYZ stock two years ago at $30. Now
the price has risen to $60, and you think that the stock has more upside. But the market is
choppy, and youd like some insurance. You might buy an XYZ 55 put (entitling you to sell
at $55 per share) for, perhaps, $300. Then you could enjoy any further gains from the stock,
even selling it at a higher price if you choose. But if the price falls below the strike price, you
are assured of realizing $5,200 ($55 per share, less your $300 premium for the put).

Writing covered calls. As discussed earlier, writing calls when you dont own the
underlying stock, is a high-risk investment. When you do own the stock, however, all you
risk is the loss of appreciation beyond your strike price.
Suppose, for instance, that you dont expect much action from that XYZ stock within
the next six months. Writing a call at $65 and collecting a premium of, perhaps, $370, you
produce a substantial income return if the stock remains below $65. You might then choose
to sell another call. If the price rises higher, however, your proceeds would be limited to
$6,870 ($65 per share plus your $370 premium for the call).
Of course, an exercise would force a sale and the recognition of a taxable gain, and this
has to be factored into your decision to write a call. Be aware, also, that a covered call gives
no protection on the downside, other than the $370 cushion provided by the premium that
you received. For that reason prudent investors often turn to a third strategy.

Creating an equity collar. A covered call can usually be combined with a protective put,
establishing at reasonable cost an acceptable range within which the investor is willing to part
with a holding. The premium received for the call goes toward paying the premium for the
put. Thus, a floor and ceiling are established.
Writing puts conservatively. Suppose that you are interested in a stock, but think that it may
decline in the short term before moving upward. Writing a put below the market price, you
would set aside the cash to purchase the stock in a money market fund or a T-bill. If the price
then falls, you acquire the stock at your target price. Of course, if the price drops precipi-
tously, youll still be required to pay the exercise price, so this technique is to be used with
caution in volatile markets.

Used protectively or aggressively, equity options add a layer of complexity to investing.


Therefore, they are best employed under the guidance of a trusted professional advisor.

2008 M.A. Co. All rights reserved.


Any developments occurring after January 1, 2008, are not reflected in this article.

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