Session 1, Lesson 8 / BASIC HEDGING STRATEGIES

In today’s lesson we’re going to look at some basic hedging strategies using the purchase of put options. I will work through extended examples, using Dow Jones Industrial Average Stocks. These example would be very typical of the type of strategy that you may employ. Please review even if you don’t trade stocks, since the concepts are uniform regardless of the market.

This example will be in Stocks. its July 1st Your investment is very substantial in cash Stocks listed on the Dow, and there is a great deal of uncertainty as to what price you will receive in fall. In a favorable environment, prices on the index could be as high as 9200, or with good corporate earnings reports  or very strong demand even over 10000. On the other hand, if the corporate season is excellent and the world economic picture discourages Stocks investors, prices could plunge to as low as 7300. That represents a tremendous price swing which can mean the difference between your finances being in the black or the red. There is not a lot you can do to insure the outlook, and no insurance can provide  protection in case of a disaster. While you can’t change the price of the stock yourself, options can fill the same role as insurance and protect you in case of a disaster.

The mistake many traders make is to assume that an option is going to give them absolute protection from every little price move. That is simply not the case. Just like most insurance policies have a deductable, and you must bear some of the risk, the same is true with options. You are not going to protect your price penny-for-penny, but by careful selection of the right option and good timing, you can protect yourself from a disaster and keep yourself in business. Options are simply another management tool to help you control your risk.

Seasonally stock prices tend to work higher into the months towards year end and peak most often after that, the strategy you would employ would be to purchase a put option which gives you the right, but not the obligation, to sell at the strike price you select. Normally a December corn option would be used, since that gives you price protection all the way through harvest. Normally options are purchased with a strike price very close to the current futures price, as far away or options with longer time before expiration are expensive as the buyer pays for the time value.

Remember – the value will decrease if futures stay at the same level because of the time decay. If you decide to hedge some of your Stocks portfolio with this option, you would instruct your broker to buy 9000 December CBOT Dow Jones Index Put at 100 index points X 10 dollars = 1000 dollars  cover the amount of your portfolio that you selected. The floor price that you would be establishing for your Stocks  would be 9000 less the 100 index points premium less transaction costs (40 Dlrs) for a total of $1040. For simplicity, we’ll assume that your basis equals 0, but you could adjust this figure according to your local situation. What this means is that you have now set a floor price of 9000 for your stocks.

Let’s advance our example to one months time in October. As it turns out, the economic pattern has turned bad and December DJIA futures have now dropped to 8200. So now how do you take advantage of this hedge protection?  You would simply sell your stocks locally and receive the price at 8200 on the index equivalent. You would then no longer need the protection of your option, so you would have two choices. You could either exercise the option, which means you would convert it into a futures position and then offset that futures hedge or you could simply offset your put option by selling it back. Offsetting the option would be the most likely strategy. If you were to offset your option, its minimum value by this time would be 800 index points x 10 = 8000 Dlrs. That figure is arrived at as the difference between the 9000 strike price and the current futures price of 8200.

In effect, the 800 points represents the cash value of the option. There may also be some time value remaining which would simply improve your profit on the position. For simplicity, we’ll assume that there is no time value by this point. We instruct our broker to sell back the option and receive 800 points for it. That 800 points, however, is not pure profit. We must first subtract the 100 points  premium which we originally paid plus the 4 points  commission that we paid. Doing so gives us a profit of 696 points  on our option. We now add that 696 points to the 8200   cash price we received and have a realized price for our stocks at 8696. Notice how our realized price equals the breakeven or floor price which we calculated earlier.

Now if the market had headed higher towards the 10000 mark the Stocks Investor would simply sell his cash stocks at the higher cash market price, and since his put strike price is at 9000 and the market is at 10000, there’s no reason for him to take a selling position at 9000 when he could always sell higher at the market, henceforth he lets his option expire and loss is his premium, but he benefits from selling cash stocks higher at the market, the option gave the insurance he required

Answer to assignment from Lesson 7:

EXAMPLE: PROBLEM 1:

Buy Mar 575 soybean put for $.16 Buy Mar 230 corn put for $.12

Strike price = $5.75 Strike price = $2.30

– premium = .16 – premium = .12

– commission = .02 – commission = .02

Breakeven = $5.57 Breakeven = $2.16

PROBLEM 2: PROBLEM 3:

Buy Mar Chi 370 wheat put at $.15 Buy Feb $74 live cattle put for $1.00

Strike price = $3.70 Strike price = $74.00

– premium = .15 – premium = 1.00

– commission = .02 – commission = .25

Breakeven = $3.53 Breakeven = $72.75

SUMMARY

— Buying a put option is one of the most basic hedge strategies used. — Put options are normally purchased to establish a floor price and protect from market declines. — Even in a rising market, the purchase of a put option can be valuable in case of the unexpected. — Options will not cover penny-for-penny moves in the market, but rather will help protect you from disastrous price movements. — Purchasing options must be part of a complete plan and not done on a hit-and-miss or sporadic basis in order for success to be more likely. In Lesson 9 we’ll look at other strategies for hedging against a market decline.