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Robert earned a bachelor’s degree in computer engineering from the University of Illinois at Chicago. He attended DePaul University to complete a master’s degree in finance and also earned the Chartered Financial Analyst® designation. Robert worked as a stock options trader at the Chicago Board of Trade, where he was responsible […]
Hedging Strategies For Protecting Profits In Los Angeles Forex Trading
There are times when an investor finds themselves with a single stock that makes up an uncomfortably large portion of their overall portfolio. Having a focused position is a double-edged sword; On the plus side, you’ve accumulated some wealth, but the problem is that your fortune is now inexorably tied to a single company. Of course, you could sell the stock and diversify, but if the position is held in a non-retirement account, there can be significant tax implications. Sometimes there may be sentimental reasons for holding a position.
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Hedging is a strategy that involves buying or selling a security to reduce the risk of loss in another position. The value of the hedge should appreciate if the value of the position you are hedging declines, offsetting some or all of your losses.
Hedging can be understood as insurance in the sense that it pays off in the event of unfavorable outcomes. However, as with insurance, insurance has its costs. The cost of hedging can vary depending on how much downside risk you want to cover, and sometimes it can even be free if it’s structured a certain way. You’ll also want to keep in mind that you may lose some potential appreciation in your underlying investments due to hedging.
These costs and benefits should be weighed. Then, depending on your risk preferences, you can decide whether to hedge your investment and, if so, to what extent.
While various instruments can be used as a hedge, the most common instruments used as a hedge are options.
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An option contract gives the buyer the right, but not the obligation, to buy or sell an asset at a specific price, called the strike price, on a specific date, called the expiration date. For a stock option that would give the buyer the right to buy or sell the stock at the strike price before the expiration date. Some options can be exercised at any time before the expiration date, while others can only be exercised on the expiration date.
There are two types of options. Call options give the buyer the right to buy the underlying stock at the strike price. Put options give the buyer the right to sell the underlying stock at the strike price.
The price you pay for a stock option is called the premium. An option’s premium depends on factors such as the current stock price, the option’s strike price, interest rates, the option’s expiration date, stock dividends, and the stock’s expected volatility.
You can hedge your downside risk in stocks by buying put options. Owning a put gives the holder the right to sell their shares at the exercise price of the option. This essentially acts as an insurance policy, setting a floor on the investor’s share price for the duration of the option. However, as with any insurance policy, the investor pays a premium to get downside protection.
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Let’s say you’ve owned 100 shares of Apple (AAPL) for several years at $80 per share, and the stock is now trading at $150. Let’s say you’d rather not sell the stock, but you’re concerned about the possibility of a price drop in the next few months.
To secure this position, you might consider a protective pull. Each option contract represents 100 shares, so you would buy 1 contract because you own 100 shares. Let’s say you decide to buy one $120 contract that expires in 6 months at a premium of $3.60. So the price you would pay for this option would be $3.60 *1 contract* 100 shares per contract = $360.
By paying this premium, you would be insured against losses of less than $120 per share. However, you would still suffer losses from the current price of $150 to $120.
If AAPL shares fall to $100 by the time the option expires, then your option ends up being “in-the-money”, exercising it and selling 100 shares of AAPL at $120 per share. If the stock ends up at $120 or higher by expiration, your $120 put will expire worthless and you will lose the premium you paid for the $360 option.
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Hedging with a long option is the simplest, but also the most expensive type of hedging. Let’s look at another strategy that provides protection but may be cheaper to implement.
A collar is a strategy in which you sell a call and buy a put at the same time. The idea is that the put protects your downside, while the proceeds from selling the call pay some (or all) of the price of that put.
While the advantage of the collar strategy is that it can be an almost costless hedge, it also has a downside. You have the risk that your shares may be called back (sold) if the price moves above the strike price of the purchase you are selling. Recall that when you sell one call option, you are required to sell 100 shares of the stock to the buyer of the call option if the stock is trading above the strike price of the call on the expiration date. So you run the risk of selling your stock position if it appreciates significantly in value, which could result in capital gains taxes being realized.
Let’s look at an example scenario where a collar hedging strategy might be something you would consider.
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Let’s say you own 800 shares of Microsoft (MSFT) as the main holding in your portfolio. You have owned a stock for many years and you don’t want to sell it because you think it will appreciate in the long term. If you were to sell, you would also incur large capital gains taxes and prefer to defer those taxes for as long as possible. However, you are concerned about the impact that a large drop in prices could have on your overall financial health. You want to fully hedge this position, but prefer to hedge as cheaply as possible. In this scenario, you might consider a collar strategy.
Let’s say MSFT stock is trading at $280 and you can buy $200 that expires in 12 months for a premium of $7.20. A strict $200 put option gives you protection for MSFT below $200. Instead of paying the put premium out of your own cash, you sell the covered call at the $360 strike to fund the protective put purchase and get $7.00. You would buy and sell 8 contracts of each because you own 800 shares.
That $160 cost is relatively small considering you’re insuring nearly a quarter of a million dollars worth of Microsoft stock.
Collars tend to be the most popular strategy for protecting the value of a portfolio or large, concentrated stock position. However, it is important to remember that your upside is limited if the stock rises above the strike price of the call. In this way, collars can limit both your losses and your profits.
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A put spread is simply a long and short put position. For example, when trading MSFT stock at $280, you can buy a put at $250 and sell a put at $230. Selling the $230 put partially offsets the cost of the $250 put. In this example, your stock position would only be hedged if the stock price drops from $250 to $230. If the stock price falls below the $230 floor, the gains on the long put will be offset by the losses on the short put.
A put spread can be a cheaper way to hedge your stock position than an outright long protective put. However, it also provides more limited protection against adverse effects.
A covered call strategy consists of selling out-of-the-money call options against a long stock position. This strategy can be used to generate income if you believe that the share price will tend to move sideways. When you sell a call, if the stock price at expiration is below the call strike, you get a premium. Although this strategy does not reduce the downside risk, the premium you receive helps mitigate potential losses to some extent.
However, this strategy has a downside. If the stock price is higher than the call option’s strike price by expiration, you will be “assigned” to the call and obligated to sell the stock at the strike price. If you don’t want to sell the stock and just want to get the premium on the option sold, you can always buy the option back before the stock recovers to the strike price.
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