Hedging – Using Covered Calls and Put Options to Hedge a Position
It’s no surprise that investors are becoming just as concerned with protecting what they have as they are with making profits. Globalization of the world’s economies and foreign events, typically negative, are affecting the markets in a big way, and are doing so more frequently. In order to combat the increased potential of market sell-offs, investors are learning to hedge their positions to try to minimize their losses.
There are two basic ways to hedge a position:
1. Selling call options (covered calls)
2. Buying put options
Each way is a separate school of thought, and each has its advantages and disadvantages. On reviewing each, you will see that both have an optimal use scenario. One is best under a certain condition, while the other is better for a different scenario. These two scenarios are subjective. They are created by a combination of current market conditions along with your prediction of future conditions. Finally, there is a third potential hedge, which is actually a combination of the first two.
To make matters simple, let’s start with a basic position of being long 100 shares of Transocean Ltd. (NYSE: RIG ) at $72.50. In this way, keeping it simple, we can plainly see the difference between the two different hedging philosophies.
By selling calls we are initiating a position whereby we are bringing in money (credit) against our long stock position (debit). The idea here is that as the stock trades down against us, the call we sold will lose value, creating a profit in the call position that helps offset the loss in the stock.
As long as we sell one call for every 100 shares of stock owned, this position we have created is a strategy known as the covered call strategy .
For example, say we decide to sell one August 75 call at $5.60. If the stock trades down to $69 at August expiration, our stock position will have lost $3.50. However, with the stock under $75, the calls we sold will expire worthless. Having sold the call at $5.60, and having it expire worthless, we will have a $5.60 profit in the short call position. The profit from the short call will more than offset the $3.50 loss in the stock and actually give us a $2.10 overall profit in the position.
Following this rational, the short call will cover us up to a $5.60 loss in the stock. This means that the stock could actually trade down to $66.90 without losing any money. So, at $66.90 in the stock, the entire position neither makes nor loses money. This point is called the breakeven point.
The breakeven point for this strategy is calculated by taking the stock price and subtracting the call price. If we follow the formula and take the stock price ($72.50) and subtract the call price ($5.60) you would get the breakeven price ($66.90).
So, this hedging philosophy covers us immediately from the stock price of $72.50 down to the breakeven of price of $66.90. In reality, if the stock trades down but does not reach $66.90, the position will actually make money as demonstrated earlier with the stock trading down to $69. The problem with this form of hedge is that it only covers you down to the breakeven point in the stock, in this case $66.90. If the stock trades lower than $66.90, the position will lose dollar for dollar with the stock.
For instance, say the stock was to trade down to $60. At that price, you will have lost $12.50 in the stock ($72.50-$60) but have made $5.60 in the short call. Remember, with the stock at $60 (which is below the $75 strike) the call that you shorted will expire worthless and you will collect the full value of the call. Making a long story short, your total loss in the position will be $6.90.
Looking at the breakeven formula, your total loss is calculated by simply calculating how far below the stock is from the breakeven. With the stock at $60, it is $6.90 below the breakeven point ($66.90), thus a $6.90 loss. The further the stock trades down from here, the more money is lost at a dollar-for-dollar pace.
In conclusion, the covered call strategy offers a limited hedge that covers you down only an amount specified by the breakeven point. It is very cost efficient and best used
when you expect the sell-off to be a shorter-term movement that will not be too steep.
The other technique for hedging our long stock position is to buy a put option. Unlike the sale of a call that is a credit trade, the purchase of a put is a debit trade meaning that money is going out.
In a sense, purchasing a put is much the same as buying life insurance. The money you spend covers you in the face of potential disaster. So, if there is no disaster, that money spent is now gone. But that was money well spent to protect you, just as buying “portfolio insurance” is money well spent to save you from the potential loss of your retirement account and the years of work to build it!
Let’s look at an example. Sticking with our previous scenario, let’s say we are long 100 shares of RIG at $72.50. We decide to purchase the August 70 put for $5.80 to protect our downside.
If the stock were to trade down to $69 at expiration, we would see a loss of $3.50 in the stock and a loss in the put. You see, at August expiration, the August 70 put would be worth only $ at that point, giving us a $4.80 loss in the put also. The combined loss here would total $8.30.
Do understand, these results are at expiration. Between now and expiration, many things can happen while the put still possesses extrinsic value (the difference between the entire price of an option and its intrinsic value, or time value). But the point here is that the put does not help much if the movement is shallow and longer lasting.
However, if the sell-off is more aggressive in both time and size, the put performs better, meaning it protects you better. If the stock traded down to $50 for example, you would see a $22.50 loss in your long stock position. But, in this case, the put would have served you well. The August 70 put would be now worth $20. You paid $5.80 for this put, which is now worth $20, so your put will have a $14.20 profit. Combine the put profit with our stock loss and our total loss is only $8.30.
Compare that with the covered call strategy and you can see the difference. With the stock at $50, the covered call would have produced a $16.90 loss.
Where the covered call strategy will cover you down to a certain point (breakeven point), it will not cover you down below that. It grants you minimal protection. The protective put, however, does not cover you until a certain point (breakeven point) but will cover you as far down below it as the stock price trading to zero. It grants you maximum protection. It will limit your loss to a specific maximum amount.
That maximum loss amount can be calculated by first calculating the breakeven. This can be done by subtracting the put price from put’s strike price. In this case, with the put price of $5.80 and the strike price of $70, the breakeven point will be $64.20. Now, if you take the current stock price ($72.50) and subtract the breakeven point ($64.20), you will get the maximum potential loss ($8.30). The advantage in the put purchase is that no matter how low the stock may go, the absolute most you can lose is that $8.30.
In this day and age, hedging is critical to sustainable portfolio growth. Here are two pretty basic, straightforward hedging techniques that have two different types of results and are, for the most part, tailor-made for two different scenarios.
With a little work you can learn these two strategies and prepare yourself for the next big sell-off. But before studying these two and thinking you know all there is to know, let me tell you now that there is actually a third strategy called a collar. It combines the best of both the covered call and the protective put but, alas, that is an article for another day!
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