November 8th, 2014
by Russ Allen, Online Trading Academy Instructor
In the last two articles, which you can read here and here, I've been discussing using options as a hedging, or risk-reducing device. First, I discussed using put options as a hedge against a stock position. Then last week, we looked at how an options market maker hedges his positions, which is sort of the same thing in reverse. Today we'll look at other variations of options as hedges.
First, a reminder of our definition of a hedge: an additional position used in combination with another position, to reduce its risk.
In options, the situation of the two parties to the option contract is fundamentally different. The buyer of the option pays the option seller an amount equal to the option price, and this amount is called the premium. This premium represents the option buyer's maximum loss. The option buyer's profit is unlimited.
On the other side of this trade, the person who sold the option now has unlimited risk, which he accepted in exchange for being paid the option premium. This premium, which is already in his hand, is the option seller's maximum profit.
It is pretty clear that "unlimited risk" is not a comfortable position to be in. This is a position that could definitely benefit from a hedge.
Here's an example. Below is the chart of IWM, which is the exchange-traded fund that tracks the Russell 2000 Small Cap Index:
Trader Al sees IWM at around $114.00, approaching a downtrend line, and believes that it will break down. He believes that by December IWM could revisit its most recent swing low around $104.
He wants to benefit from the expected drop in the price. Checking the option chain for IWM, he finds that he can buy a December put option at the 114 strike price for $3.44 per share. Al buys the put. If he is correct about IWM and it goes down to $104, his right to sell the stock at $114 could be worth $10 ($114 guaranteed sale price from exercising the put, less $104 required to buy back the resulting short stock at its market value to close out the trade). If IWM goes even lower than $104, then his put option will be even more valuable. In the theoretical "best" case for Al, IWM would become worthless. His right to sell it at $114 would then be worth the full $114. This is so large compared to his original $3.44 investment, that by convention we refer to the maximum profit on put options as unlimited, even though the stock can not go any lower than zero.
If Al is wrong about IWM, and it does not drop, his worst case is that he could lose the $3.44 he paid for the put option.
Now, when Al bought that option, someone sold it to him. Let's say that it was trader Bev. She felt that the $3.44 option premium on the IWM December 114 put was a juicy premium. She did not believe that IWM would drop. She hit the Sell to Open button at the same time that Al hit the Buy to Open button, their orders crossed, and she is the short seller, or writer, of the put that Al bought.
Bev's position is now the exact mirror image of Al's:
Al paid the premium of $3.44. This is his maximum loss.
Bev received the premium of $3.44. This is her maximum profit.
Al's maximum profit is unlimited.
Bev's maximum loss is unlimited.
Al needs IWM to drop. If it doesn't, he loses 100% of his premium paid.
Bev needs IWM not to drop. If it doesn't she gets to keep 100% of the premium received.
If IWM drops further below $114, but by less than the $3.44 premium, Al loses some, but not all, of his premium.
If IWM drops further below $114, but by less than the $3.44 premium, Bev gets to keep some, but not all, of the premium.
Al's loss is inherently limited, because he can not lose more than his $3.44 premium. He does not need a hedge (although later we will see that he might choose to use one anyway).
Bev has no limitation on her loss. If she does want to limit it, she will need a hedge.
To hedge her position, Bev could spend part of the $3.44 that she received to buy an insurance policy of her own. For $.87, she can buy her own December put at the $104 strike price. If IWM should drop below $104, this put will begin to pay her a dollar for every additional dollar the $114 short put is costing her. In the worst-case scenario, with IWM dropping to a value of zero, she will have to pay out $114 on her original short put; but she will be paid $104 on her long put. Her net amount out of pocket can never exceed this $10 difference ($114 - $104). Bev's loss is now limited - her position is hedged.
This hedge does not remove all risk of loss. But it does provide disaster insurance. That insurance was not free - it cost her $.87. So Bev's maximum profit is now $3.44 less the $.87 cost for the insurance put, for a net of $2.57. This is now her maximum profit.
Bev's reduction in risk here is dramatic. Instead of potentially having to pay up to $114 per share to extract herself from this trade, she now can never pay more than $10 per share. Her maximum risk now is that $10, less the $2.57 net premium she received, or $ $7.43.
It may not be so obvious or dramatic, but in fact Al could hedge his long put too, if he wishes. This would be a hedge in the sense that it would reduce his maximum loss. He could, in fact, do the exact opposite of what Bev did. He could sell that $104 put for $.87. His net out of pocket is now also $3.44 - $.87, or $2.57. This is his new maximum loss.
This hedge is not free money. It reduces Al's maximum profit from "unlimited" down to $7.43. Just as Bev now can never have to pay more than $10 to get out of this trade, Al can never receive more than $10 when he exits either, no matter how much lower IWM goes.
This transformation of the long put into a hedged position may make good sense for Al too, even though it reduces his maximum profit. If he believes that $104 is as low as IWM is likely to go by December, then he would believe that he is not really sacrificing much in exchange for that $.87 cost reduction, which is a pretty large fraction of his original $3.44 cost.
In summary: Option writers benefit from hedging because it transforms their unlimited-risk positions into limited-risk positions, but at a cost. Option buyers may also benefit by modifying their positions to reduce cost, since that also reduces their maximum loss.
Deciding whether to make the "anchor" option in our position a long option or a short one, and choosing which option to use as a hedge, is what constitutes option mastery. For details on how to learn to do this yourself, and much more, contact your nearest Online Trading Academy center.