Very nice RM, one day I too will have a firm, grasp on those strategies
OK, here is my simple explanation of hedge puts and straddles. I am by no way an expert on options, do not guarantee the accuracy of the following, which may be wrong, and only offer it in the spirit of group learning which we are all doing. So anyone feel free to correct anything I have here that is wrong, especially Poet who actually attended a class on this stuff.
Buying a put to hedge common is the simplest and most ultra-conservative way to deal in options. Even with covered calls you take the chance that your stock will be called away. With a hedged put, there is little downside but you enjoy the upside.
For example, you buy 100 shares of XYZ at $100 per share, for a total of $10,000. You also buy a, say, May 100 put for, say $10 for $1,000 cost, so your total investment is $11,000.
Say the stock goes to $120 before the option expires. You now have $12,000, for a profit of $1,000 + whatever the residual value of the option is. So you don't have as much upside as if you only held the common (you would have a $2000 profit), but you also have little downside risk, as the following shows:
Say the stock goes to $80 before the option expires. You now have $8,000 for the stock, but the option will be worth at least $2,000 (intrinsic) + whatever time value remains. So you still have at least $10,000, and your downside was only the value of the option.
Now, say the stock crashes to $50, in a week such as today. If you did not have the put, you would have lost $5,000, or 50% of your investment. Unfortunately, many options traders did just that and worse this week. With the put, however, you would have $5,000 for the stock + $5,000 for the put's intrinsic value + whatever time value remained (minimal). So you would still have at least $10,000.
Now say you think the bottom is here and the stock is going back up. You close the put, keep the cash, and ride the stock back up. (if you're wrong you can always but the put back) If you don't think the bottom is here, you keep your put in place, and go to sleep knowing the most you will lose is 10% (the cost of the put) even if the market completely crashes.
Of course, when the put expires, you have to decide what to do, close it or roll it out, depending on market conditions. If you keep doing this month after month, eventually the puts will cost too large a % of your investment. But for short one or two month periods of craziness like we have seen, this is a good strategy.
The other strategy is a straddle, you buy a put and a call at the same time and the same strike.
Say XYZ is at $100, and you buy one put and one call each for $10, for an investment of $20.
If the stock stays between $90 and $110 before expiration, you lose $2,000, although if it looks like the stock is going sideways for a while you can close out your options and at least take some money back.
But say the market crashes, and the stock goes to $50. Your call may drop to $2 (say), but your put is now worth $50 intrinsic + say $2 time value, or $52. You now have $5200 + $200 = $5400 on a $2000 investment. If the stock does just the opposite, and goes to $150, you have the same amount. This is good for markets that are totally schizo and you think they may move down or up big time, but you don't know which way they will go. I have May straddles on GMST, for example.
What I did is almost but not quite as simple, because I left a gap between my common and my puts, so I suffered more of a downside, but with the crash I am not totally hedged.
There are other more sophisticated versions of this strategy, but for that I would have to take a class like Poet did. |
