The Best Way to Hedge a Risky Market

by Ron Ianieri | May 26, 2010 4:04 am

The Best Way to Hedge a Risky Market

In a recent article, we discussed the two basic ways of hedging your long stock position[1].

1. Covered Call Strategy

We talked about the premium collection way, which was selling calls to bring money in to help offset any loss we would have if the stock started to trade down. The advantages of this form of hedging are that we do not have to put out any money to do it and our downside coverage picks up immediately.

The disadvantage is that our position is only covered as far down as the premium collected. If the stock trades down further than that, we lose dollar for dollar as far down as the stock may go, so this is a minimum coverage hedging strategy.

2. Protective Put Strategy

The other form of hedging is the premium outlay way, which is to buy puts. Here, we would be putting out money in order to make the purchase of the put. Besides the obvious disadvantage of having to come up with additional money, the protection you purchased does not pick up immediately. The stock will have to drop, and you will have to absorb some loss before the put really kicks in and stops the bleeding.

The advantage, however, is that, once the put kicks in, it gives you full protection from that point (the point of maximum loss) down to zero in the stock. In this way, you can fix your potential maximum loss to a predetermined amount, so this is a maximum protection strategy.

Which is the Better Strategy?

Without too much thought, one can see the advantage of the protective put strategy in a market that trades down fast and hard with seemingly no bottom in sight.

The problem is, when the market trades down like that, implied volatility[2] increases, sometimes dramatically, as we have recently seen. When implied volatility increases, the prices of all options, both puts and calls, increase. The more the market trades down, and the faster it does so, the more volatility increases. The more volatility increases, the more expensive protection gets until it reaches the point of becoming prohibitive.

At this moment, you might say that the covered call strategy is the better choice because you are selling options[3] and the high volatility level will play in your favor, as you will collect more premium from the sale of the calls as opposed to having to lay out additional money, potentially a prohibitive amount, in order to buy puts.

The only problem is that if the market is trading down that hard and that fast, you really NEED the maximum protection that the protective put strategy offers. So, with option prices so expensive during this type of sell-off, the dilemma becomes quite apparent.

How to Hedge in a Volatile, Risky Market

Think about the problem for a second. With a quicker, more aggressive sell-off, you want the protection that the protective put strategy offers, but you do not want to pay too much for it. There is a point where insurance becomes too expensive. It would be a different story if there was some way to finance the cost of the put.

Well, there is. We can combine the strategies and sell a call too, thereby bringing in premium that can be used to offset the premium laid out for the purchase of the put. Suddenly, the maximum protection that seemed so expensive is completely affordable.

This combination of the covered call strategy and the protective put strategy is called a collar, and is ideal for obtaining maximum protection at a minimal price.

A collar is constructed by being long 100 shares of stock, long one put (normally out of the money), and short one call (also normally out of the money). The 1-to-1 ratio is necessary to create the collar.

For the option gurus out there, the collar is synthetically equivalent to the bull spread. But, for you option laymen, the collar is a perfect protection strategy for high-volatility, high-risk situations.

Option Collar Example

Let’s take a look at how it would work.

Say, for instance, you own Research In Motion Limited (NASDAQ: RIMM[4]), and it is trading at $57.60. You purchased it much cheaper and you wish to protect your profits. But this sell-off has been very aggressive and implied volatility has spiked considerably.

Your first instinct is to buy some puts. The RIMM July 55 Put, however, is trading for $3.75, which is pretty expensive. If the stock were to hold here or go up, the loss in the put would be a relatively high percentage loss in a relatively short amount of time. In this sense, the put may be prohibitive in price.

So, you take a look at the RIMM July 60 Call, which is trading at $3.60. If you sell that call, then you generate $3.60 in proceeds, which would offset your capital outlay for the put purchase. Suddenly, the put is very, very affordable. You only have to reach into your pocket for 15 cents. Sometimes, collars can even be put on for credits.

Now, you have obtained your maximum downside protection for a minimal cost. The protection kicks in very quickly and extends down to zero on the stock.

There is, of course, a cost to putting on the collar. In order to obtain your maximum protection for a minimal price, you have given up your potential unlimited upside profit that you would have if you simply purchased the put and did not sell the call. The thought process here, though, is that if the sell-off is so serious that you feel it necessary to purchase puts for downside protection at this high level of volatility, the odds of the stock skyrocketing back up are probably minimal. So the unlimited upside potential is probably not necessary at this juncture compared to the need for the maximum downside protection.

Our position has full downside coverage for a minimal price. Our cost is mainly an opportunity cost in that we have given up our unlimited potential upside profit by selling calls to finance the puts we purchased. But, at times like these, giving up a potential upside gain is well worth the need to protect what we already have. At times like these, the collar is king!

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Endnotes:
  1. hedging your long stock position: http://www.optionszone.com/trading-strategies/option-strategy-basics/hedging-using-covered-calls-and-put-options-to-hedge-a-position.html
  2. implied volatility: http://www.optionszone.com/learn-more/john-jagerson/understanding-how-implied-volatility-affects-options-traders.html
  3. selling options: http://www.optionszone.com/learn-more/jim-woods/put-writing-and-call-writing-explained.html
  4. RIMM: http://studio-5.financialcontent.com/investplace/quote?Symbol=rimm
  5. Get your FREE copy here!: http://www.optionszone.com/order/?sid=HB3208

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