Wednesday, April 8, 2009

Protective Put Hedging Example

Allow me to continue Monday’s post on how one can use options to lower their position delta by offering a protective put example. Suppose we are currently long 100 shares of AAPL which we purchased at $105. With AAPL currently residing at $115, we’re sitting on an unrealized gain of $1000. What is our position delta? You guessed it, + 100. This means that my positions P/L will increase $100 for every $1 increase in AAPL stock, and will decrease $100 for every $1 decrease.
To lower my net delta - thereby lowering my exposure- I could buy a protective put. Let’s assume I purchased a May 105 put for $4.00. The delta on the put is currently -27. If I add the -27 delta of the put to my stocks +100 delta it reduces the net delta to +73. Thus, if the stock drops $1, rather than giving back $100 of my $1000 gain, I only give back $73. Furthermore, the delta on the put will increase as the stock falls (it’s getting closer to the money), which will decrease my positions delta incrementally. For example:

AAPL @ $115 Net Delta = +73
AAPL @ $114 Net Delta = +71
AAPL @ $113 Net Delta = +68
AAPL @ $112 Net Delta = +64
Etc… If you are ever considering using options to hedge but don’t yet understand risk graphs, simply look at what adding an options positions does to your existing position’s delta. If it increases it, then adding the option is making your position more sensitive a downward move in price. If it decreases it (like our protective put did) then adding the option is making your position less sensitive to a downward move in price.

Tyler-

2 comments:

Anonymous said...

Hey Tyler:

General question:

I understand that you favor 4-6 weeks out options strategy (I am thinking options spread trade), and let the time decay work for you. But would you consider a week or 10days befoire the options expiration, spread strategy provided you get say $1 premium credit for a $5 option spread and you are prepared to take the chance that the stock will move in your favor and thus you pocketing the premuim by the expiry?

The reason I ask you think is because is there any specific reason for your 4-6 week play as you seem to favor OTM spread strategy.

TIA

Tyler Craig said...

TIA,

1 week out it's very rare to find an OTM credit spread that brings in $1 credit that has a high enough probability of profit for my taste. Although you may find spreads that bring in $1 credit that close to expiry,they would have to be pretty close to the current price, resulting in a lower probabiltiy of profit. That's my rationale for going 4-6weeks - I can go far enough OTM to fit my comfort level.

Others may prefer going closer to expiry, but I don't.

Tyler-