By Jeff Bailey*
Investors have heard the phrase "hedging a position" but may not know how to implement a hedge. Recent events have, perhaps, heightened the level of market uncertainty, and now may be an appropriate time to discuss one way to hedge a position.
Let's imagine that we own 100 shares of ABCD at $35 and want to hedge this position should the stock decline further. Recent events may have us feeling the stock is vulnerable to the $23 level, which has been a level in past trading where the stock has rebounded. Let's imagine that shares of ABCD finished trading at $30. In essence, the stock has declined $5 per share since purchase, and, now, we want to hedge that position.
When shares of ABCD open for trading, we may not want to sell the stock and REALIZE a loss. Instead of selling ABCD for a loss, we may want to hedge this position for a period of time using a put option. A hedge like this gives the investor the opportunity to "buy some insurance" on the stock held in his / her account for a period of time.
Let’s assume that we want to hedge into January. Because our example is that a trader owns 100 shares of stock, a hedge would be to buy 1 put contract (1 contract equals 100 shares).
Let’s now assume that the ABCD January $30 put (ABCMF) was offered at $2.30. Let's assume that the stock opens for trading at $30.
If a trader buys 1 contract, his / her outlay of cash would be $230 plus commission paid. Once the option is bought, our hedge would be as described in the following paragraphs.
We would still hold long 100 shares of ABCD with a cost basis of $35 ($3,500). Once the put option is bought, the trader has established the RIGHT, but not the OBLIGATION to sell his / her stock at $30 between now and the January option expiration (Friday before the 3rd Saturday of January). This transaction costs the trader $230. (Note: A hedge position is considered a "neutral" position.)
Should the stock eventually fall to the $23 level (before option expiration), our 100 shares would be worth $23 ($2,300), but our January $30 put would be worth approximately $7 ($30 strike of option -- $23 market price). As you can see, the put option has increased in value; thus, we've hedged against the downward move.
If shares of ABCD do fall to $23, and we do not hedge our position, our original investment of $3,500 will be worth $2,300 (paper loss of $1,200).
The hedged position under outlined assumptions would have required a total cash outlay of $3,500 (underlying stock), plus the $230 (cost of option excluding commissions), for a total cash exposure of $3,730. At a market price of $23, the HEDGED POSITION would be worth $3,000 ($2,300 in stock + the now $700 value of put option).
The previous example demonstrated a hedge position on a stock where we were already at a loss. Many institutions and investors will hedge positions that are currently in the position of profit. I would argue that the options market was originally created to allow investors the opportunity to hedge and help mitigate risk, not speculate on stock price direction.
*Article reprinted (and modified) with permission from OptionInvestor.com
