away. Keep in mind that short options can
be assigned at any time up to expiration,
regardless of the ITM amount.
To avoid assignment, you might consider buying back the calls at the higher
price. If closing out the calls isn’t a choice,
you might simply wait to have your stocks
called away. You’ll keep the cash from the
sale of the calls and potentially profit on the
sale of the stock at the strike price (
assuming you sell the stock for more than you
paid for it). But you’ll also lose ownership
of the stock and miss out on any additional
appreciation above the strike price.
EVEN TRADERS NEED PROTECTION.
But if hedging with index options seems
foreign to you, consider it as simply adding
a new dimension to your put strategy—in
other words, an indirect way to hedge
your holdings. The key is to make sure that
whatever index you might choose correlates well with your portfolio.
HOW IT ALL PLAYS OUT
Should your portfolio decline in value, the
correlating index you’ve hedged against (in
this case, OEX) will likely decline in value as
well, increasing the value of your puts. Ideally, you want the increase in the put value to
offset the decline in your portfolio value. At
any point before the puts expire, you could
likely close out your hedge and the net proceeds would be swept into your account.
You might decide to use any gains to buy
more stock at cheaper prices, or simply put
on a new hedge at the index’s lower prices.
The maximum potential return for a long put
is limited by the amount the underlying can
fall. Remember, this strategy provides only
temporary protection from a decline in the
price of the corresponding index. Should the
long put position expire worthless, the entire
cost of the put position would be lost.
On the other hand, should the markets
continue to rise and as OEX moves further
away from the put strikes, your hedge will
begin to lose less than your portfolio gains.
That’s because of the “convexity” of options
during the life of the trade. Figure 2 shows
what happens to your position at expiration, without considering convexity, when
there’s no time premium left in the hedge—
in which case, your effective cost is now the
stock price plus the put price.
HOW DO YOU PAY FOR IT?
Of course, there’s always the possibility you
don’t have $16,000 at your disposal. And
you may not want to sell part of your portfolio to raise the cash to buy the hedge.
You might consider selling calls against each
of your stock holdings to offset some of the
cost of the put hedge. Provided you own a
minimum of 100 of the underlying stock
shares per each call you sell, you’re “covered”
and may not need to incur additional margin
requirements. The premium you get from
the calls reduces
the cost of your put
hedge. If the calls
you sell are the
same distance from
the stock price as
the put hedge, the
credit you receive
offset the entire
cost of the put. Your
new position is now a “collar” on the stock.
(For more on collars, see page 18.)
But watch out for caveats. If the stock
price moves in the money (ITM) beyond
the short call strikes, you could be “
assigned” and get your stock position called
FIGURE 1: Beta weighting your portfolio. The Beta Weighting tool in the thinkorswim® platform from
TD Ameritrade converts the deltas of individual positions into index-equivalent deltas.
Source: thinkorswim from TD Ameritrade. For illustrative purposes only.
Kevin Lund is not a representative of TD Ameritrade,
Inc. The material, views, and opinions expressed in
this article are solely those of the author and may
not be reflective of those held by TD Ameritrade, Inc.
For more on the risks of trading and trading
options, see page 38, #1 & 2.
*Prices listed do not include commissions and
FIGURE 2: Protecting an egg. With a stock and put
position (solid line), the maximum risk is defined. You
could still have unlimited upside potential, but your
break-even price increases. For illustrative purposes only.
STOCK VS. STOCK WITH PUT HEDGE
Stock + Put
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