If you read my column last week, How Stock Investors Can Hedge Against Severe Losses, you learned how to use put options to prevent devastating losses in your stock portfolio — without sacrificing all your upside potential.
Today I’ll share another hedging technique. This one let you hedge all the downside risk in a stock without paying for it!
Of course, there’s a catch.
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Every trading strategy has trade-offs. However, all successful trading strategies have optimal timing and market situation set-ups.
Even better, hedging with little or no out-of-pocket expense is possible.
You can do it while you are waiting for an earnings report or key economic numbers, or for a macroeconomic danger zone to pass.
The catch is that you must give up most of the stock’s upside potential while you are hedged.
To hedge downside risk without increasing your cost basis, you sell call options against your stock position and then use the proceeds to buy puts.
Option traders call this hedging strategy a collar.
Remember, when you "sell to open" (as opposed to "selling to close," or exiting) an option, you accept an obligation.
If you short a call option, you must sell your shares if the person who bought the call wants to buy them.
Let’s run through an example with the same eBay (EBAY) trade I used as last week’s example.
In the hypothetical scenario, we bought shares of eBay at $55 and the stock went up to $70 (remember, these are examples and not actual prices).
The Week 4 July $70 Put is trading for $2. You could sell ("sell to open") the Week 4 July $75 Call option and buy ("buy to open") the Week 4 July $70 Put.
Because you would collect a credit on the short call and pay a debit on the long put, you could end up breaking even or paying a slight debit/collecting a small credit to put on an options collar!
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(Remember, by just buying the put, we would have paid $2. Collecting a credit on the short call could reduce or even eliminate that cost altogether, before broker fees and commissions.)
You can adjust your collar for an ideal fit as the stock price moves.
For example, you could also buy the July Week 4 $65 Put and sell the July Week 4 $75 Call option for a small credit, perhaps $1.
That’s right — depending on which options you choose, you could actually get paid to create the hedge.
Note that we are "collaring" the stock with options in the same expiration month/week. You choose the strike prices based on where the stock is trading.
But be careful; the only way to get a credit is to allow for a bigger downside loss. That doesn’t necessarily mean it’s a bad trade, only that the credit doesn’t come free.
For example, say you sold the $75 call and bought the $65 put for a net credit of $1. This means you receive $100 per contract.
Now, what does the profit and loss look like at option expiration?
Now compare this profit/loss (at expiration) table to the table last week.
You can see how we have sacrificed upside potential, as our max gain with the collar is only $21 regardless of how high the stock goes.
The collar allows profits on the downside.
Bottom line: Hedging is a way to maintain upside potential, either limited or unlimited, and to reduce or eliminate downside loss.
Wise hedging can make a big difference in your investment success.
Watching your chickens,
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