Options explained

using options as tools for hedging, 4 techniques available to anybody

using options as tools for hedging, 4 techniques available to anybody

September 17, 2009 – Comments (10)

I am of the opinion that in many, although not in all, of the stocks that I hold that it is a good time to take some gains.

However, for one basic reason I am not want to sell them right now and that reason is taxes. Its a 20% difference in tax rate for me if I sell now (have not held even 1 share for 12 months) -vs- january, february, march, and april (some shares bought after that but not all that many).

Could I find an investment that would make more than 20% between now and then and thus make a better return by selling, paying up to the tax man, and then re-investing in this other thing? Of course, but... is it likely that I will successfully find that +20% investment? Maybe... but it isn't guaranteed, and as such at times hedging may be desireable.

Another reason to desire a hedge on a long position would be that you believe the market is going to correct, and stocks you own are going to go lower with it, but you still believe that in time the names you hold can move higher. A hedge can temper the short-term pain or even provideprofts you can re-invest after such a correction takes place, if it does take place.

There are several paths we could take to hedge our bets with options and these are the focus of this blog.

First, some background: there are two kinds of options. A call, and a put.

A call is a contract between you and someone else where one party agrees to give the other the right to buy a share from them by a certain time for a certain price in exchange for a premium. For an example, right now you can buy a January 2011 $45 call for ASH for about 10 bucks. If you buy this call, you pay someone else (maybe me) 10 bucks. You then get the right to buy 1 share of ASH from me for $45 anytime before january 2011. In this case you would profit if ASH went to $56 or higher, because you paid $10 and would pay me $45 for the share, and thus would have $55 into your share, and selling for $56 would yield $1 of profit. If ASH went to $70 your profit would be $15.

You would buy a call if you thought a stock is going to go up. You would short a call if you thought that the stock is going to go down, stay flat, etc.

A put is the opposite. A put gives its buyer the right to sell a share to someone for a given price upuntil a given date. You can buy a $40 put for ASH right now for jan 2011 for about 8 bucks. So you would pay $8, and you would then get the right to sell 1 share of ASH anytime between now and jan 2011 for $40. So by buying the put you are essentially guaranteeing that you can sell the share for $32 anytime between now and jan 2011 (you sell for $40, you paid $8 for the put, netting $32).

Option contracts are sold in lots of 100. So each time you make such a move you are working in lots of 100 shares, you can't buy a contract for 80 shares.

The farther into the future the expiration date is, the higher the premium (cost) of the options are. That $45 call for ASH costs just 30 cents for September 2009 (3 days). For january 2010 it costs about $4.50, and for jan 2011 it costs $10.

From time to time these contracts are executed before their expiration date, but this is rare. On several occasions I have sold covered calls that were in the money and had someone forget to call the shares. Without exxageration, I have kept 100 WYNN shares, several thousand XL shares, and several thousand TCK shares due to such mistakes. As those happened in April... I'd say i've benefitted from someone elses carelessness.

Option 1: buying a put. If I own a share of ASH and I'm satisfied with the gains (from a cost avg of $6 something to $44, pretty satisfied) I could buy a put. I bought all of my shares of ASH between january 2009 and March of 2009. To get to the 12 month i-can-sell-now-and-pay-capital-gains-taxes I could buy a put for April 2010. This gives me the right to sell the shares for $XX at a time when I can pay capital gains.

I buy a put for $45 (close to todays price) and it costs about $7.50. I would then lock in a selling price of net $37.50 anytime between now and april 2010.

If ASH goes to 60 here, I net $52.50. If it goes to $70 I net $62.50. If it goes to 20 I net $37.50. If it goes to$45 i net $37.50. Basically, $37.50 becomes my low and my upside is unlimited.

If ASH corrects temporarily to, say, $30, my put would become worth more, probably about $16 or $17, and I could then sell it for a profit, ... and then experience all the future upside in ASH from $30. My point is you don't have to hold these things to expiration, you can trade them.



Option 2: selling a call. If you own shares of a stock and sell a call against that stock (short the call) that is called a "covered call", you're covered because you own the shares which eliminates any risk of losing money from this transation...

So, I own a share of ASH and i'm satisfied with the gains. I decide to hedge by selling a covered call, say a Jan 2011 $45 call. I take in $10 in premium, and I can do whatever I want with that $10 immediately.

Now my position in ASH looks like this: if ASH goes to $70 I net $55. if ASH goes to $11,080 I net $55. My upside is limited to the strike price + the cash I took in from the call. If ASH goes to $45 I net $55. if ASH goes to $30 I net $40 because I took in the $10 of premium.

My upside is limited here, but I keep the $10 no matter what. I can reinvest it (so I win no matter how limited my upside is if I put it into an investment that does better than my upside loss in ASH) and so forth. If the shares don't move up or down at all I eventually make $10.

Over time if the stock goes sideways, the premium will melt away and you can buy it back at a profit. If the stock goes down the premium will melt away and you can buy it back at a profit. And so forth.



Option 3: a collar. You collar a stockby selling a covered call, and then using the premium to buy a put. You spend $0 on this transaction (or very little anyway, or you may profit very little, depending on what strike prices you choose).

Take a share of ASH again. say I decide that ASH might go up a little bit more, but i'm willing to risk it going down a little bit as well. I could sell an jan 2011 $50 call, which would get me $8 or so of premium. I could then take that $8 of premium and buy a jan 2011 $40 put with it.

I now never get less than $40 for my share, but never more than $50, I have essentially range-bound the stock. This is a slightly bullish, but just slightly, hedge.



Option 4: a synthetic short. I am long ASH, say I've decided thats it, I'm happy with the gains, I just want to lock it right exactly here. I can do that!

To make a short position with options you simply buy a put and sell a call at the same strike price. You are now, with some potential for negative or sometimes positive arbitrage due to bid/ask spreads and relative prices on puts and calls, short the stock. It goes up $1, you lose $1, it goes down $10, you make $10 on these options positions.

So in this case I'd buy an april 2010 put at $45 for about $7.40, I sell an april 2010 $45 call for about $6.30, and I have locked my net sale price for ASH at $43.90 ($45 less the difference in options costs). It costs me $1.10 per share to do so, I wind up about 8 cents ahead of the current price.



So... basically... lets take a look at how we might want to use each of these options, I'll pick some examples from my real life portfolio.



I am long XL capital. It pays a now-modest (huge at the time I was buying XL) dividend of about 2.5%, it may well raise that dividend in the future. It is also trading under book value (insurers historically trade at a small premium to book value) and further it probably is looking at additional mark-ups to its book value in coming quarters, it has a forward p/e of 7.8 (that is hardly rich) and frankly I think in the fullness of time XL goes higher from here. I'm comfortable holding it. I think in the fullness of time XL trades to 1-1.2 of tangible book and a p/e of 10. I think XL goes to 22-25 bucks.

However, I also think that the market is primed for a pullback, and if financials get hit XL gets pounded along with them because its not the largest cap and when someone buys FAZ or SKF XL gets shorted in the process. This makes XL volatile as all get-up and always ripe for a big drop in share price.

So i think XL goes higher but as my position in it is huge (nearly 10% of my total portfolio) i'd like some shelter in case it tumbles down. Its run up to $18 now, I have a few options

1. I could buy a jan 2010 put for about $1.10 at $15.00. If XL tanks to $15 in the next month or 2 that will wind up worth probably only 2 bucks, as every day that goes by some time premium ticks out of the options. But, if XL tanks soon to $15 the value of that will swell to probably about 3 bucks. If XL tanks soon to $12 it'll be worth probably about 4 bucks, etc. (the farther "in the money" an option is th eless time premium it exhibits.

I don't really like buying puts as the best way to hedge as A) time is not on your side. Every day that goes by your asset (the put) becomes less valuable all other things equal. And B) they don't really protect you completely unless you buy one thats already well in the money, and thats expensive.

But doing this would buy you 4 months of more or less secure vacation I guess...??



2. I could sell a jan 2011 covered call at $25. This brings in about $2.20. Time is on my side now, and if XL stays flat I win. If XL goes to $22 soon, the value of that call will swell to probably $3-$3.50. So I'll gain $4 in the share, but lose $1ish, which tempers my on paper gains. If XL then 6 months from now drifts down to $20 again, the value of that call will probably fall to $2 or so again and so forth.

I like this move because I get large upside (40%) + the call premium (meaning net 50+% upside), I get cash in my hand which I can do whatever with, and if the stock dips the cost of buying that put back will drop quickly and I will profit that way if I wish (or i can just let it ride).

If XL really tanks, like say to $5, ... I am not very protected at all... just by $2.20. But XL isn't going out of business and I think its going to do well in the future, and as I'm willing to hold XL i'm not concerned about a disastrous outcome, ... so i'm ok without the big downside protection.

This is a semi-bullish hedge. I'm leaving big upside, don't have completedownside protection, but could profit from the hedge if XL prices stabilize or drop.



3. I could collar XL. Sell the $25 (about the high side of where I think its going so no big deal if it gets there and the shares get called) and then buy the $12.50 put. No downside below $12.50 upside to $25. I can now walk away and just let time run its course, or I could...

imagine XL then dips to $15. The value of that $12.50 put, which I own, will swell and I can sell it at a profit. The value of that $25 call will drop, and I can buy it back at a profit.

So if i'm really sure XL is going to correct, I can do this and benefit more from a pullback than if I just sell the covered call. My upside is lower (because I bought the put).

This hedge isn't really bearish or bullish, but sort of neutral.



4. I could take out a synthetic short. If XL tanks to $12 I make $6 per hedged share essentially staying at $18. I could then cover, re-invest the profits, and experience upside in the futurre (after covering).

this is a bearish hedge. you're betting that more upside isn't in the cars and that at some future date the share will be lower than today.



5. I could sell an in-the-money or at-the-money long term covered call. This brings in alot of premium and provides better downside protection. I could sell a $17.50 call for jan 2011, bring in about $4.50 or about 25% of todays share price, invest that however I wish, still have some slight upside, but have 2x as much downside protection as the $25 call.



recently I've sold covered calls as described above against ASH (alot of them), XL (some), GNW (some) at prices I calculated to about roughly where I think the upper end of fair value for those stocks is, typically with 25-50% upside left from here. I'm bigtime under water on the ASH calls even though none of them are in the money, such is life.

I sold an in the money covered call on every share of WYNN when it hit like $62. I think i got $17or so for the $60 call for jan 2011. So my upside is limited to $77, as WYNN moved up even morme since then I may opt for making my position a collar by buying a put... If WYNN hits $50 say next march that call will probably be worth about 7-8 bucks. I may then cover if I think WYNN will go higher, or I may not.

I am not bullish on WYNN here one bit. I took a similar tact on LVS and may even sort of double-down on the hedges by selling som enaked calls against it as well (i own a mob of LVS so all my calls are covered now). By doubling down on the LVSshort-calls, I am risking alot of LVS goes far higher from here. But I am fairly confident that LVS now discounts a very good outcome from future operations and i'm not too worried about going short a few $35 calls...

I collared a few stocks and so on and so on.



My hedges right now do not provide me with locked-in gains on my portfolio overall. But they do provide me with considerable downside protection (probably about 20% total but thats a WAG and the exact figure would be time consuming to estimate).

Hope that helps somebody. :)

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