Monday, April 6, 2009

Options 101: Hedging Revisited

Options are superb vehicles that can be used either for speculation or hedging. In other words, they can be used to take on risk or to offset risk.

The two most basic ways one can use options in speculating are buying a call option or buying a put option. When buying either calls or puts, the buyer is essentially betting on the future direction of the stock. If the stock makes the right sized move in the right amount of time, the option buyer stands to gain a tidy sum. Unfortunately, if the underlying doesn’t make the right sized move in the right amount of time, the option buyer stands to lose his entire investment. There is nothing fundamentally wrong or dangerous with speculating as long as it is conducted in correlation with proper money management techniques, such as only risking a small percentage of your account in any one trade.

Hedging can be thought of as reducing or offsetting risks that you’ve already accumulated. By hedging, one can lessen their exposure to an adverse move in a security they already own. Suppose you bought 500 shares of AAPL at $85 on March 10th. Currently AAPL is trading around $115, resulting in a $30 or 35% unrealized gain. Now, the dilemma that presents itself, and will always present itself, is that of knowing when to take profits. We’d like to protect our well earned gains, yet leave room for more upside potential. One of the problems with merely using a stop loss is it fails to protect you against gaps. Fortunately, options provide some very efficient ways of hedging and solving the aforementioned dilemma.

Let’s explain the concept of hedging in terms of delta. For a complete review of delta see my previous post here. Just remember, delta measures a position's sensitivity to a $1 move in the underlying.

Current Position:
Long 500 shares of AAPL: Delta = +500 (I lose $500 if AAPL drops $1)

We’ve already explained that hedging is a way to reduce risk. My current position holds +500 of delta risk. If I lower my position delta, I lower my risk. So, how can I take my +500 delta down to say +250 delta?

Method #1 – the No Brainer
Sometimes simplicity is superior! The first thing I could do is sell 250 shares of stock.

Current Position: Long 500 shares of AAPL: Delta +500
Adjustment: Sell 250 shares of AAPL: Delta -250
New Position: 250 shares of AAPL remain: Delta = +250

Given the adjustment, has my risk been reduced? Hopefully you’re answering with a resounding yes! Now I only lose $250 per $1 drop in the stock, as opposed to the $500 I would have lost pre-adjustment. Furthermore, I’ve locked in part of my gain and still have upside profit potential.

Method #2 – Use Options
Rather than recommending one specific strategy for hedging, let me expound on the rationale behind delta hedging. Once you understand the theory, there are a myriad of ways you can lower your position delta, thereby lowering your risk. I’ve shown the following table in past posts, but it bears repeating.

Positive Delta: Long stock, Long Calls, Short Puts
Negative Delta: Short stock, Long Puts, Short Calls

Since our position is positive delta, we would take one of the three “Negative Delta” actions to hedge. Method #1 already involved selling stock (the equivalent to shorting stock). In the options arena we could either buy puts or put spread or sell calls or call spreads. When Implied Volatility is high, I’d prefer buying put spreads, or selling calls and call spreads versus buying puts outright. Conversely when IV is low, I’d probably just buy puts outright.

Tyler -


John Reed said...

Hi Tyler,
I am new at trading options but I am enjoying the knowledge. I have been doing some paper trading using spreads. I have tried a bull call spread where I bought 2 months out, buying one call ATM and selling another one OTM. The underlying stock moved up very well but my spread just stayed balanced. I must have had a net delta of near zero. Do you try to get a higher delta on the buy and a low delta on the sell option for this type of strategy?

Thanks for your help.
John Reed

Tyler Craig said...

Hey John,

Thanks for the question. The short answer is yes, your net delta on the call spread was probably pretty low. I look at call spreads as position trades - time needs to pass for the trade to mature and really come to fruition. You could try to get a higher net delta, just remember that it will increase your risk. The other alternatives are simply being patient and waiting or you may consider a 1 month bull call spread, which will mature quicker. The drawback is you have less time to be right.