using Options as Stock hedge?

Discussion in 'Options' started by marcoPolo21, Apr 16, 2011.

  1. Hi all,
    I've just opened an account over at Interactive Brokers.

    I'm wondering about using Options as a stock Hedge.
    I'm not thinking 100% insurance.
    I'm willing to take 50% of the stock risk naked,
    hoping most of my picks are correct.
    Let's say Long stocks held overnight, and longer.

    Would a reasonable strategy be simply to buy a variety of Puts?

    thanks
    marc
     
  2. rew

    rew

    Buying puts is the obvious way to hedge a stock. That's expensive, so you may want to offset part of the cost by selling covered calls, (making it a collar trade) although that limits your maximum gain.

    Of course buying a stock and a put on that stock is just creating a synthetic call, so you may as well buy a call at the same strike as the put instead.
     
  3. Just buying a Call might accomplish what I want.
    Do I give up anything, just buying a Call? Dividends come to mind.

    Initially,
    I thought for every 200 shares of stock I would buy 1 Put,
    for partial insurance, and just fade 1/2 the downside risk.

    marc
     
  4. You can buy puts on your individual stocks if you're trying to hedge individual risk. If you fear a market collapse then buy index puts.

    The problem with buying puts is that most of the time, it's a waste of money. That means that you need to be a lot more right with your stock selection and timing in order to overcome this insurance cost. And if the protective strike is 50% away (I'm assuming you're not playing with $5 stocks), it will be a rare occurrence for them to come into play.

    As rew suggested, buying calls is the same as put protected stock (assuming you're buying the puts when you buy the stock). If not, then it's stock first and hopefully buy puts later to protect gains (tho not in your 50% drawdown scenario).

    Collaring the stock (buy OTM put, sell OTM call) is a good way to offset the cost of protection. As he noted, it limits the upside. If that's a major concern, widen the strikes or even unbalance them (call strike further away).

    The collar is equivalent to a vertical spread so if doing this all at once, do the vertical and save on slippage and commissions.

    Personally, I think that accepting a potential drawdown of 50% isn't wise and that you can reduce that tremendously with collars and still have 10-20 or more pt upside potential.
     
  5. Let's take an example.
    I currently own 200 shares of BRK B.
    As long as this rocky bull market continues, I would like to own 1-2,000 shares, at these prices.
    But I would want some kind of downside protection.

    I see insurance can be expensive, since options expire.

    The September Puts look reasonable, to start. But which strike price?
    I see many possible options - anywhere from a 75 strike up to a 85 strike.
    I just realised I could even buy an In The Money Put.

    Collars? I will have look into that option.
    I see I have a lot to learn.

    marc
     
  6. rew

    rew

    You do give up the dividends when you buy the call. A call is cheaper for a stock that's paying a dividend during the remaining life of the call, but not enough to fully compensate for the loss of the dividend. But note that a dividend paying stock will also have more expensive puts, so if you buy the stock and a put the dividends you collect will be partly offset by the higher price on the put due to those dividends.

    Of course you also give up voting rights when you buy a call instead of the stock but unless you own millions of shares voting rights are meaningless.

    You can certainly do partial hedges as you suggest, or buy puts on an index as a general hedge on your whole portfolio. There's no absolute best choice, as none of us can foresee the future.
     
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