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Option Hedge

Risk Management

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The biggest issue with stop losses is they don’t work when the asset’s exchange is closed. The industry is filled with stories about people who placed a stop loss on a trade which was ignored by the market during an overnight gap. An after-hours gap down on an asset purchase will bypass stops but be limited to complete loss of initial investment. An after-hour gap up on a short sale can hurt significantly since there theoretically is no upside limit to a price rise. Many people have lost multiple times their investment or even beyond total account value. Alternatively, a high volatility share trending sideways can trigger a stop loss too early. The price triggers your stop then reverses into a profitable trend.

Using An Option Hedge

There is an alternative technique to stop losses known as an Option Hedge. You can have 24/7 protection against an adverse price movement that won’t trigger early if you’re exposed to a long purchase or a short sale. Option Hedging is an insurance technique that will cost money, increasing the cost of the trade and requiring more overall price movement for gains in exchange for limiting losses. You’ll purchase a derivative option hedge.

Most people who play with derivatives speculate for profit. This is risky in most cases, but it is also extremely profitable. An Option hedge trades for downside protection, not profit. Options come in two flavors: calls and puts.

Types of Options

A call option gives you the right to purchase equity at the strike price until the expiration date only if the market price is above the strike price. If the call option is activated the market price minus the strike price is money saved on the purchase and earned as a return. A put gives you the right to sell stock at a strike price until the expiration date. This only occurs if the market price is below the strike price. If exercised, you sell the asset above the lower market value. Simply remember: a call calls an asset away from someone else, a put puts the asset towards someone else. Don’t get confused.

American or European

If you’re trading American-style options (in the American stock markets), you can exercise an option at any time before the expiration date. If you’re trading European style options remember that you can only exercise options on the date of expiration. This limitation reduces the effectiveness of European style options as insurance against adverse movements since you must wait to activate your protection. You might not last that long.

Protection Quantity

Each single option represents one share and is sold at a per option price. Option transactions come in bundles of 100 options, each option transacts one share. Multiply the price per bundle by 100, multiply the result by the amount of bundles you’re buying, then add commissions. This is the total cost of your “insurance”. You need to purchase enough options to hedge the desired amount of shares. The cost of your options must be substantially exceeded by the profit from by your trade since it reduces your gains. Lower outlays require less movement for profit.

Timing Your Option Hedge

You should remain aware that over time the value of your options will decrease as they move towards the expiration date. This is known as your option’s time value. Since your options can only be used before expiration, as they move towards the expiration date they lose their value. The rate of loss is displayed via “Theta”, also known as the options “time decay”. On the expiration date, they will only be worth money if they could actually be used. After the expiration date, they will have no value at all.

With any option hedge, you need to purchase options with an expiration date longer than the expected length of the trade. Once the expiration date arrives, your options expire, and so does your insurance. You will need to purchase new options as insurance to cover the exposed risk. Alternatively, carefully purchase very long options. As the options you purchase increase in length until expiration, the price per option gets more expensive since it has more time value.

Constructing an Option Hedge

Let’s move on to the hedge. If you own the underlying stock, purchase puts with a strike price close to the desired stop loss value. If the price falls below the strike price, exercise the put to forcibly sell the shares at the stop value. You can also sell the put and sell the shares. Increases to the put value reduce losses on the shares. Calculate and compare share losses and the put’s increase in value to know which route is best.

The reverse is also the same. If you’ve short sold the stock, buy a call (See Illustrations). If the price rises above the strike price and creates losses on your short sale, you can exercise the call. You’ll buy shares at a price below the market price, reducing losses while closing out the trade. You can sell the calls, which reduce losses on the shares. Again, compare the results of both courses of action before you make a decision.

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