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Table 10-1 (continued)
Month Strike Price Bid Ask OI*
37.50 1.25 1.45 1,338
Jan 30.00 0.50 0.60 45,795
32.50 0.75 0.85 156,657
35.00 1.25 1.35 52,734
37.50 2.00 2.15 24,225
* OI = Open Interest
Although the protective put is a relatively simple strategy, the number of ways that protection can be provided is numerous. To help with your analy- sis, identify your protection time horizon along with the maximum loss you seek prior to viewing option chains. This will aide your decision-making.
Assuming you seek protection above the stock purchase price, you then have limited your analysis to the 35 and 37.50 strike prices. Table 10-2 provides an analysis of the protection provided by select puts if you choose to exercise them.
Table 10-2 Put Short List for ABC on Aug 22nd
Month Days to Exp Strike Price Ask Delta Exercise
Oct 60 35.00 0.35 –0.186 $65
60 37.50 1.05 –0.460 $245
Jan 150 35.00 1.35 –0.291 ($35)
150 37.50 2.15 –0.440 $135
The exercise column is calculated by subtracting your purchase price from the option breakeven. From Chapter 4, the breakeven for a put option is:
Put Strike Price – Put Purchase Premium = Put Breakeven (Put Breakeven – Purchase Price) ×100 = Net Profit/Loss
Unless otherwise stated, the multiplier for a stock option is 100. When work- ing with a combined position that includes 100 shares of stock, be sure to remember to incorporate this value in the formulas.
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From this point, the actual option selected for the strategy is definitely a per- sonal decision. You may prefer longer term protection and include April put options in your review. You may only seek catastrophic coverage in which case you may add strike prices below 35.00 as well.
To wrap up the example, the 37.50 strike should be selected if you don’t want to see a profitable position turn into a loss when exercised. If you’re bearish through the entire month of October, the ABC Jan 37.50 put option provides you with protection for the full time period.
There are a variety of things to consider when seeking protection for an exist- ing stock position including:
Term for the protection (expiration month) Level of protection (strike price and option price)
You could also consider the likelihood an option will be ITM at expiration by referencing delta. By making use of options that have a greater chance of being ITM at expiration, you may find you can trade out of the protective position and use the proceeds to help finance a new protective put. The more experience you gain, the more you’ll find an approach that suits your style.
You can always sell a protective put before it expires if you feel the markets have stabilized and the intermediate outlook for your stock turns bullish again.
Since no one knows what the next day in the markets will bring, an investor may decide to maintain some level of protection on stock positions regard- less of the short-term or intermediate outlook. To minimize expenses, lower strikes may be considered as part of a plan that provides catastrophic coverage — kind of a crash protection approach.
Accelerated time decay
When trading options for this strategy or others, you need to consider the impact of time decay on the option position. Theta is the option Greek that identifies the daily loss of option value associated with the current price of the option.
Using an ABC Oct 37.50 put option with 60 days to expiration, you can obtain theta by accessing an option calculator such as the on located on the OIC Web site (www.optionscentral.com).
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The theta value for the option trading at $1.05 is –0.0078. That means if every- thing stays the same tomorrow, the option quote will lose 0.0078 in value. It may not sound like much, but it can add up.
In addition to the cumulative impact of time decay, this rate of decay acceler- ates as expiration approaches particularly within the last 30 days of an option’s life.
The impact of time decay accelerates the last 30 days of an option’s life. This means extrinsic value will decline more quickly along with the value of the option — assuming all other conditions remain the same.
To minimize the impact time decay within 30 days of expiration, trading strategies that make use of long options should incorporate an exit plan that addresses the issue. I generally exit a long option position 30 days prior to expiration to avoid accelerating losses to its extrinsic value.
Table 10-3 provides theta values for the ABC Oct 37.50 put for various days to expiration, assuming all other factors remain the same.
Table 10-3 Theta Values for ABC Oct 37.50 Put
Days to Expire Ask Theta
60 0.35 –0.0078
30 0.75 –0.0117
10 0.45 –0.0216
5 0.30 –0.0314
If you think $0.02/day is manageable, consider what this represents in terms of percentages. With ten days to go until expiration, 0.0216 is 4.8% of the con- tract’s value.
The way you go about protecting positions is similar to any other investment decision — it depends on your risk tolerance and personal preferences. Find an approach that suits your style.
Before moving on to the cost of a protective put relative to the stock, the risk graph in Figure 10-1 displays the improved risk-reward profile that results when you add a put to long stock. Losses are now capped.
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Weighing protection cost versus time
When you have a specific, reasonably short time horizon to protect a posi- tion, selecting the expiration month is pretty straightforward. Once you seek longer term protection the analysis requires a bit more effort. Since you expect the security to move upward on a longer-term basis, ATM options should be OTM by expiration and may be minimally effective. You need to weigh the cost of protection against the amount of time the protection is in place.
The investment process requires you to balance risk and reward. Without risk there is no reward, but it doesn’t mean you have to risk it all. Consider protective positions as a means of limiting your losses while letting your profits run.
Long-term protection
Suppose you noted that stock XYZ has consistently realized annual gains of 8%, even during years with a 2% decline along the way. How do you go about protecting such a position? A $2.15 ATM put that provided five months of pro- tection was used in the ABC example. Since ABC was at $37.50, the put pre- mium represents 5.7% of its value.
0
Put Reduces Risk
Price of Underlying Stock
Profit/Loss
Long Stock & Long Put
Figure 10-1:
Risk graph for a long stock- protective put position.
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Balancing the cost of protection versus returns is difficult and requires a game plan. Again, it’s not a one size fits all proposition. If you buy puts on a regular basis you could be sacrificing stock returns and then some. On the other hand, ignoring protection completely could cost you a big chunk of your initial investment.
The short answer to this problem is that you pretty much have to find the balance that is right for you. You may decide to intermittently use puts when bearish periods arise, but if you could time the markets that well you proba- bly wouldn’t need protection. Give the issue some thought.
When purchasing puts to protect your investments, be sure to balance the cost of protection versus net returns for the protective put position.
By carefully evaluating different options rather than just looking for the cheapest alternative, there is a better chance the option will have some value 30 days prior to expiration. As part of your plan consider:
The net exercise value and level of protection provided
The statistical chance the option will be ITM at expiration (delta) The cost of protection versus the net impact on returns
Being clear about your strategy goals from the start should definitely help.
Cost per day calculations
As a last consideration, when selecting protective puts:
Be careful about buying seemingly cheap puts that don’t offer adequate protection and will likely expire worthless
Consider the cost of protection over your stock holding period Using the 37.50 strike price put for ABC, you can calculate the daily cost of protection for the two options. This is accomplished by dividing the option premium by the number of days to expiration:
ABC Oct 37.50 put @ $1.05 = $1.05 ×100 = $105 $105 ÷ 60 days = $1.75 per day
ABC Jan 37.50 put @ $2.15 = $2.15 ×100 = $215 $215 ÷ 150 days = $1.43 per day
The ABC Jan 37.50 put translates to a cost of approximately $0.014 per share for the option if held to expiration.
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Do what you can to manage your positions by responding to market condi- tions, not over-reacting to them. No one can completely control their emo- tions when markets race up or come tumbling down. Do your best to manage them by completing your analysis when the markets are closed whenever possible.
Limiting Short Stock Risk with Calls
Long puts provide you with a means of protecting your investments for a spe- cific period of time. Although you probably don’t hold any short stock posi- tions in your investment portfolio, you may periodically trade strategies that use short stock position that are held overnight. A long call can protect you from losses due to overnight gaps upward.
Protecting a short stock position
In the same way a long put protects a long stock position, a long call protects a short stock position. A call gives you the right, but not the obligation, to buy stock at a specific strike price by the expiration date. You can exercise your call rights to close out a short position if the stock rises quickly.
Since a short stock position is generally held for less time, protective call option selection is much easier. Typically you can evaluate options with the least amount of time to expiration or those in the following month. Stocks with options will have both months available.
Option months that are closest to expiration are generally referred to as near month optionsand those that expire right after that are referred to as next month options.
In addition to paying less for time for the protective call, strike price selec- tion should be easier since there is less of a chance the stock will move far away from the entry price in the relatively short period of time the position is held. Try to use options that matches your maximum loss criteria.
Further reducing short stock risk
If you’re really committed to reducing short stock risk, why not just consider implementing a long put strategy to capitalize on your bearish view for a par- ticular stock? Suppose you didn’t own stock ABC and you are bearish on the
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stock instead. How does a long put position compare to a short stock posi- tion? Assuming ABC is trading at $37.50, Table 10-4 compares a $37.50 put to the stock position, including maximum risk and reward:
Table 10-4 Bearish Positions for ABC on Aug 22nd
Position Entry Cost Max Risk Max Reward
Long 1 Oct 37.50 Put $105 $105 $3,645
Short 100 Shares ABC $1,875 unlimited $1,875
Here’s what you need to consider:
Stock entry cost:The initial cost for the short stock position is 50% of the current stock price because short selling has a 150% margin require- ment. 100% is credited to the account from the stock sale and the remaining 50% is cash you need to have available for the position.
Stock maximum risk:Since the stock can theoretically rise without limit, the risk to a short seller is also considered to be unlimited. You may try to limit this risk by having an order in place to buy the stock back if it rises past a certain price, but overnight gaps in the stock could result in this maximum risk stop level being exceeded.
Option maximum risk:The maximum risk for a long option position is the premium paid. In this case, that’s $105.
Option maximum reward:If you own the right to sell a stock for $37.50 and it is currently trading at $0, the intrinsic value of the option will be
$37.50. Theoretically you can buy the stock in the market for $0 and then exercise your right to sell it for $37.50. The $1.05 you paid for this right must be subtracted from the $37.50 per share gain for the stock transac- tion to determine the maximum reward for the option position.
Option breakeven level:The breakeven point for the option position is the put strike price minus the option price, or $37.50 – 1.05 = $36.45.
Puts increase in value when a stock decreases and represent a bearish posi- tion. Although they are wasting assets that are negatively impacted by time decay, they have limited risk and limited, but high reward potential.
Looking at your risk first, the put position limits the maximum risk to $105.
This is equivalent to a $1.05 per share amount that could easily be exceeded with an overnight gap in the stock. From a reward standpoint, you’re reducing the maximum gain by the cost of the put ($105), but you have the potential to far exceed the short stock reward when comparing the gains on margin.
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Hedging Your Bets with Options
You can use the following options to protect stock positions:
A long put with a long stock position A long call with a short stock position
The option can be exercised to close the stock position or gains in the option can be used to off-set losses in the stock. The term hedgedescribes a posi- tion used to off-set losses in a security resulting from adverse market moves.
Protecting a position or portfolio with options is a form of hedging. But not all hedges are created equal . . . some are more perfect than others. A perfect hedgeis a position that includes one security that gains the same value that is lost by a second security. The gain offsets the loss. So a $1 dollar move down in ABC coincides with a $1 move up in XYZ.
The option Greek delta obtained using an option calculator provides the expected change in the option’s value given a $1 change in the underlying stock.
Protecting a portfolio . . . partially
You partially hedge a position when you own a security that gains value when the hedged position loses value. Usually, when you combine two securities that tend to move in opposite directions you find it’s not always a one-to-one relationship. A $1 gain in one stock may correspond to a $0.75 loss in another security. Assuming the relationship between the two continues, combining them provides you with a partially hedged position.
Delta can be used to help construct partially or completely hedged positions.
Hedging stock with stock options
The ABC Oct 35.00 put option has a delta of -0.186. Assuming you own 100 shares of ABC and the Oct 35.00 put, the expected impact to your account with a $1 decline in ABC is calculated as follows:
(Change in Underlying) ×(Delta) = Change in Option (–1) ×(–0.186) = +0.186
When the stock moves down to $36.50, the option should move up to approx- imately $0.54. The stock position lost $100 and the option position gained
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about $19. Because the Oct 35.00 put gained value when the stock lost value it provided a hedge for ABC. However, the option gain was smaller than the stock loss, so it’s only a partial hedge for the position.
Listed index options have different characteristics than listed stock options.
For instance, an index is not a security so its not something you can buy and sell. As a result, index options settle in cash rather than the transfer of a physical asset. See Chapter 9 for details on options characteristics.
Hedging a portfolio with index options
Because listed options are available for both stock and indexes, portfolios can be protected on an individual position basis or with index options, assuming the portfolio is well correlated to a specific index. Hedging your portfolio may actually require both an index option for a group of stocks and individual stock options for others that don’t correlate well with a given index.
Correlation is a term used to describe the relationship between data sets.
The values range from –1 to +1 and when applying to stocks provide you with the following information:
Stocks with returns that move in the same direction, by the same magni- tude are said to be perfectly positively correlated (+1)
Stocks with returns that move in the opposite direction, by the same magnitude said to be perfectly negatively correlated (-1)
Stocks with returns that do not move consistently in terms of direction and magnitude are considered not correlated (0)
As an example, suppose you have a $150,000 portfolio that is well correlated to the OEX, trading at approximately 680. One quick approach to partial hedging uses the portfolio value and index strike price to estimate the hedge.
OEX index options are available for different months in five point strike price increments. When it is trading at 682, a 680 call will have $2 of intrinsic value since option moneyness is the same for index and stock options.
Using a short-term protection approach, Table 10-5 provides potential put candidates for next month options expiring in approximately 60 days. These options may seem pricey, but a five-point move in the index reflects less than 1% of the index value.
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Table 10-5 Put Option Chain Data for the OEX
Month Strike Price Bid Ask Delta* OI
Mar 665 8.60 9.30 -0.321 1,663
670 10.00 10.50 -0.361 3,277
675 11.30 12.10 -0.406 748
680 13.20 13.90 -0.455 2,883
*Delta using the Ask value
A common multiplier value for an index is also 100, so the total option pre- mium for March 670 put is $1,050 ($10.50 ×100). The option package is valued using the strike price and multiplier, or $67,000 for the March 670 put (670 ×100).
The option multiplier is the contract valued used to determine the net option premium (Option Market Price ×Multiplier) and the deliverable value of the option package (Option Strike Price ×Multiplier).
Suppose you decide you want to protect the portfolio against market declines greater than two percent. You can estimate the hedge by starting with the current index level (682) and subtracting the decline you’re willing to accept to obtain a starting point for strike price selection as follows:
682 – (682 ×0.02) = 13.6 682 – 13.6 = 668.4
Both the 665 and 670 strike prices can be considered. Using the 665 put option:
Protection Provided by 1 Put: 1 ×665 ×100 = $66,500 Protection Provided by 2 Puts: 2 ×665 ×100 = $133,000 Portfolio Protected: $133,000 ÷ $150,000 = 88.7%
If the OEX drops below 665, your puts gain intrinsic value at a pace that is equal to the put’s delta. The further the OEX declines, the closer the puts get to a 1:1 move with the index. The time remaining until expiration will also affect the actual gains made by the hedge.
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At-the-money (ATM) puts and calls have deltas that are approximately 0.50.
Once an option moves from ATM to in-the-money (ITM) or out-of the-money (OTM), delta changes in value. The option Greek that provides you with a feel for just how much delta change is gamma.
A stock option package generally represents 100 shares of the underlying stock. When using the strike price and multiplier of 100 to value the option package, it’s common to think your paying the strike price for each share of stock. That’s okay when applying this to regular stock options, but it’s not quite accurate when considering index options or adjusted stock options. In both of these cases, it’s best to consider the option package value as simply:
Strike Price ×Multiplier
A stock option package is typically 100 shares of stock. When put contract rights are exercised, the stock option owner receives the strike price times the option multiplier — usually 100. The amount the put option holder receives is also called the option package exercise value.Other terms you may see for this value include:
Option package assignment value Option package deliverable value
It depends on what side of the option you’re on. All of these terms refer to the same thing, the money that is exchanged when the rights of a call or put contract are actually exercised.
Protecting a portfolio . . . completely
Recall in Chapter 3, that delta was given the following ranges:
Call: From 0 to +1 or 0 to +100 Put: From 0 to -1 or 0 to -100
To better discuss hedging, it helps to use the alternate range of 0 to +100 and 0 to –100 for delta. That’s because it turns out that one share of stock has a delta of 1. Using this information and the ABC example, the Oct 25 put with a delta of –0.186 provides a near perfect hedge for 19 shares of ABC stock.
ATM calls generally have deltas that are slightly greater than 0.50 while ATM puts are generally slightly less than 0.50. Using 0.50 as an approximation is usually fine for the initial strategy evaluation.
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