Saturday, March 27, 2010

Using Options to Hedge your Stocks

***Disclaimer***
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (the "ODD"). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes. In order to simplify the computations, commissions, fees, and margin interest and taxes have not bee in included in the examples used in this presentation. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. No statement within this presentation should be construed as a recommendation to buy or sell a security or to provide investment advice.
With no trades this week, I had a lot of time to catch up a couple on a couple of strategies that most beginners and traders know about, but either do not understand well, or apply them incorrectly.


Let me share a few thoughts on the following well-known as well as not-so-well-known strategies.


Covered Call


A covered call position consists of the following:


Long 100 Shares
Short 1 OTM Call


This is probably the first strategy that option beginners trade.


Premium received from sale of short call helps reduce the break-even price for the stock.


There is still unlimited risk to the downside if the stock price drops.


The position is similar to a naked (short) put option.


If the stock price does not reach the OTM call strike price by expiration, we get to keep the premium from the short call.


Married Put


Long 100 Shares
Long 1 ATM or slightly OTM Put


Buying a protective put for your stocks in your portfolio is one of the first options trades that beginners also execute.


Your stock is protected by the long put should the stock price drop.


You have to pay the premium for the put option. It can be expensive.


The break even of your position is higher because of the premium that you paid


If the stock price stays above the put option strike price, the put option will be worthless (you've lost the premium the you paid).


Most people view this as similar to having insurance on your house or car. We are insuring our stocks.


This position is similar to the long call option.


Standard Collar


Long 100 Shares
Short 1 OTM Call
Long 1 ATM or slightly OTM Put


The premium received from the sale of the OTM Call option are used to either fully or partially fund the purchase of the Long Put option.


The breakeven of your position is slightly higher if the cost of the long put option was not fully funded by the sale of the short OTM Call


This position is similar to a long call vertical spread also known as a Bull Call Spread


RWT Collar


Long 100 Shares of volatile stock (e.g. GOOG, BIDU)
Short 1 OTM Call
Long 1 OTM Put


The key for this strategy is the stock selection. The stock must move. The more it moves the better. We are not concerned about the direction of the move, as long as it moves.


Similar to the mechanics of the standard collar however there are strict rules on distance OTM of the long put and short call as well as steps to dynamically manage the position should the stock price rise, fall, or consolidate. In a nutshell:


1. If the Stock sells of (goes down in value), sell the Long OTM Put


2. Use the money to purchase more stock (similar to dollar cost averaging, but using the proceeds of the Long Put sale rather than your own capital)


3. Purchase more OTM puts to protect your increased stock holdings


4. Repeat if Stock Sells Off


5. If stock price increases in value by one strike increment, re-collar using higher strike prices for the Short OTM Calls and Long OTM Puts


6. If the stock price consolidates between the Call and Put strikes, your option positions will expire. If the purchase of the long put option is not fully funded by the sale of the short call option, then you will lose the difference between what you paid and what you sold. You will make a choice to either wait a couple of months for the stock to break out of the range or simply change to a more volatile stock.


Dream's Ratio Collar


Long 100 Shares of volatile stock (e.g. GOOG, BIDU, GS)
Short 1 OTM Call
Long 1 OTM Put
Short 2 Further OTM Put


Similar in mechanics as the RWT collar.


The sale of the 2 Further OTM Puts are used to offset the cost of the long put. This position is in fact a combination of the covered call plus short put ratio spread.


There will be a credit for the short call, as well as a credit for the short put ratio spread.


The credits reduce the break-even price for the stock.


If the stock consolidates between the Short Call and Long Put Strikes, We get to keep the credit!


This however still leaves the position with unlimited risk to the downside and will tie up substantial margin.


PRB Collar


Long 100 Shares of volatile stock (e.g. GOOG, BIDU)
Short 1 OTM Call
Short 1 ATM Put
Long 2 OTM Put


Similar in mechanics as the RWT collar.


The sale of the ATM Put is used to offset the cost of the long put. This position is in fact a combination of the covered call plus put ratio backspread (long put ratio spread).


Similar to dream's ratio collar, there will be a credit for the OTM Call and a credit for the put ratio backspread.


The credits reduce the break-even price for the stock.


If the stock consolidates between the Short Call and Short Put Strikes, We get to keep the credit!


With this position, the unlimited downside risk is eliminated, however the credit received for the put ratio backspread is substantially less than the credit received for the short put ratio spread in dream's ratio collar.


Which collar will perform better? Only time will tell!


-randomjaywalking

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