In order to combat the increased potential of market sell-offs, investors are hedging their positions to try to minimize their losses. Each way is a separate school of thought, and each has its advantages and disadvantages. On reviewing each, you will see that both have an optimal use scenario. One is best under a certain condition, while the other is better for a different scenario.
These two scenarios are subjective. They are created by a combination of current market conditions along with your prediction of future conditions. Finally, there is a third potential hedge, which is actually a combination of the first two. In this way, keeping it simple, we can plainly see the difference between the two different hedging philosophies.
By selling calls we are initiating a position whereby we are bringing in money credit against our long stock position debit. The idea here is that as the stock trades down against us, the call we sold will lose value, creating a profit in the call position that helps offset the loss in the stock. As long as we sell one call for every shares of stock owned, this position we have created is a strategy known as the covered call strategy.
This point is called the breakeven point. The breakeven point for this strategy is calculated by taking the stock price and subtracting the call price. Looking at the breakeven formula, your total loss is calculated by simply calculating how far below the stock is from the breakeven.
The further the stock trades down from here, the more money is lost at a dollar-for-dollar pace. In conclusion, the covered call strategy offers limited hedging that covers you down only an amount specified by the breakeven point. It is very cost efficient and best used when you expect the sell-off to be a shorter-term movement that will not be too steep.
The other technique for hedging our long stock position is to buy a put option. Unlike the sale of a call that is a credit trade, the purchase of a put is a debit trade meaning that money is going out. In a sense, purchasing a put is much the same as buying life insurance. The money you spend covers you in the face of potential disaster. So, if there is no disaster, that money spent is now gone.
Do understand, these results are at expiration. Between now and expiration, many things can happen while the put still possesses extrinsic value the difference between the entire price of an option and its intrinsic value, or time value.
But the point here is that the put does not help much if the movement is shallow and longer lasting. However, if the sell-off is more aggressive in both time and size, the put performs better, meaning it protects you better. But, in this case, the put would have served you well. Compare that with the covered call strategy and you can see the difference.
Where the covered call strategy will cover you down to a certain point breakeven point , it will not cover you down below that. It grants you minimal protection. The protective put, however, does not cover you until a certain point breakeven point but will cover you as far down below it as the stock price trading to zero. It grants you maximum protection. It will limit your loss to a specific maximum amount. That maximum loss amount can be calculated by first calculating the breakeven.
In this day and age, hedging is critical to sustainable portfolio growth. Here are two pretty basic, straightforward hedging techniques that have two different types of results and are, for the most part, tailor-made for two different scenarios.
With a little work you can learn these two strategies and prepare yourself for the next big sell-off. But before studying these two and thinking you know all there is to know, let me tell you now that there is actually a third strategy called a collar. It combines the best of both the covered call and the protective put, but alas, that is an article for another day!
Tell us what you think here. Download your FREE copy here. Article printed from InvestorPlace Media, https: Earnings reports to watch next week: Breaking news sponsored by. There are two basic ways to hedge a position: Selling call options covered calls 2. Buying put options Each way is a separate school of thought, and each has its advantages and disadvantages. Selling Calls By selling calls we are initiating a position whereby we are bringing in money credit against our long stock position debit.
Buying Puts The other technique for hedging our long stock position is to buy a put option.More...