Column 18. Hedging

Column 18

Hedging

December 21, 2002

Terms that may be new to you are defined at end of this page.

In addition to being used as investment tools to predict (a polite way of saying bet on) price direction, options can be used to hedge a position. A hedge is an investment used to reduce the risk of holding another asset and involves taking an offsetting position in a related security.

We have seen how options are used to hedge a long stock position. That strategy is called covered call writing and has been discussed in previous columns. It is also the main focus of my book, The Short Book on Options.

Options can be traded alone, or in combination with other options. When traded as a combination, each different option is called a leg and the resulting positions are hedged positions called spreads. When you enter an order with your broker to initiate a spread, the order is called a spread transaction.

Why should you enter orders as spread transactions?
A spread transaction

Is the safe way (compared with entering separate orders for each leg) to initiate a spread position because

Must be filled on all legs, or else you receive a "nothing done"

Your broker cannot report that you bought (sold) only one of the legs (leaving you with a risky positon, and one that you did not want to have)

Why would you want to hedge?

To reduce risk

To lock in a profit

To invest even less money compared with buying options

To take advantage when one option series is priced out of line, compared with other options

Reducing risk.
Example
You own ABCD stock and are concerned about losing money if the stock declines in price. In order to hedge your position, you can

Buy ABCD puts. These puts are a hedge because

They are an offsetting position

They decrease in value if you profit from a stock price increase

They increase in value if you lose from a stock price decrease

Looking at the entire hedged position, your loss is limited because

You have the right to sell your stock at the strike price

Your maximum loss is known and locked in (selling stock at the strike price)

Sell ABCD calls. These calls are a hedge because

They are an offsetting position

If the stock price increases, you lose on the calls, but make a greater amount on the stock

If the stock price decreases, you gain on the calls, but a lesser amount than you lose on the stock

Your protection is limited, as the most you can gain is the premium collected from selling the call option. Your potential loss is still substantial, but it has been reduced

Sell some of your stock

This is an easy way to reduce the risk of owning stock. However, if you want to continue to hold the stock position, hedging with options allows you to do it more safely

Lock in a profit
Example
You bought an option, paying a premium of 2. You were correct, the stock made a big move, and your option is now priced at 6.

You can, of course take your profit

But, if you want to continue to hold this position, you can open an offsetting position to lock in a profit. Let's see how this works

You own 5 TUVW Oct 60 puts and paid 2 ($200 each)
The stock has dropped in price, and your puts are now trading for 6
How do you lock in a profit?

The easiest way is to close your position and take a profit of $2000

$400 per option; 5 options

You can sell 5 TUVW Oct 55 puts for 3 ($300)

Your position is now: Long 5 "Oct 55-60 put spreads"

You cannot lose money on this position, as you already have more cash than when you started (paid $1000, collected $1500)

The Oct 60 puts can NEVER be worth less than the Oct 55 puts

You have additional potential profit

If the stock is below 60 at expiration, you will be able to sell your Oct 60 puts, as they have an intrinsic value

If the stock is 55 or lower at expiration, then your Oct 60 puts are going to be worth 5 more than the Oct 55 puts. This represents an additional $2500 (5 points x 5 option spreads) in cash

Maximum potential profit = $500 (already collected) + $2500 (potential), or $3000

Discussion on hedging to be continued in the next column
Glossary. Definitions from today's new vocabulary

Hedge - An investment made to reduce the risk of holding another investment. It involves taking an offsetting position in a related asset

Offsetting - Moving in the opposite direction. A position acting as a hedge

Series - An individual option, specifying type (call or put), underlying, strike and expiration. For example: IBM Jan 60 put is an option series; IBM Oct 55 call is an option series

Spread - A hedged option posiiton consisting of 2 or more legs

Leg - One part of an option spread

Spread Transaction - A simultaneous options trade consisting of 2 (or more) legs. The legs are offsettiing - another way of saying the position is hedged.

Intrinsic value - The amount by which an option is in the money

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