Buying a Put - Hedging vs. Speculating

The put is an powerful tool to the investor because it can be used as both a tool for the speculator and a long investor looking to hedge.

1) First, let's examine how a speculator can use a put:

Take Google, which recently had news that the government would look into its anti-trust behavior.  The stock is currently at $475 (rounded slightly). You believe that the price of Google (GOOG) will decline between now an August. One strategy is to short the stock; but that incurs the cost of borrowing the stock. In addition, potential margin calls and unlimited go along with shorting equity.
Herein come options:

Say you believe the stock will fall to $450. The $475 (The At The Money) put option is currently trading for $20.50.  If you are indeed correct, then you will make $4.50 per stock ($450) total. The break-even point of a speculation put for this option is the strike ($475) minus the cost ($20.50):
475-20.50=$454.50.
If the stock drops below $454.50, then money will be made. If the stock is indeed $450 in August, you will buy the stock at cost ($450) then exercise your put. This put gives you the right to sell the stock you bought at $475, a $25 per share gross profit. Subtract the $20.50 you paid for the shares, and you have a $4.50/share profit.

If you are wrong, and the stock shoots to $550, you can only lose the $20.50/share ($2,050) you bought the option for.
Shorting equity would equate to $75/share ($7,500). A "stop order" can be placed if the stock raises (say, above $500). This will limit the loss from being wrong. However, if the stock rises above $500 before dropping to $450, a short position would lose money, where the put would profit.

2) Let's now assume you own Google. You are long Google, believe in the company, but are worried about the downside of this potential lawsuit. In that case, you can buy a put to protect your investment. You can hedge your position as follows:

Let us say that you buy a $475 (the current stock price) put. If the stock goes up to $550, you make money (profit $75/share), as you own the stock, but the put expires worthless. You lose $20.50/share on the put, for a net profit of $49.50/share.

Now: Assume the stock goes to $450. You can use your put to sell the stock at $475, curbing the potential loss from the stock's drop. Instead of losing $25/share, you only lose $20.50/share.

Here are the three strategies compared side by side. Notice that a hedge put makes money by the stock increasing in value, where a speculating put earns money by a drop in the price. The traditional long will out perform the hedge put, but has a larger downside risk.

My LinkedIn Strategies, cont. (Strangles and Butterflies)

In my post last week, I discussed two straddles of LinkedIn. Today, I'm adding two strategies traders who expect the price to move in either direction can employ.
Note: the price of LNKD has moved since my first post - so some numbers have been updated for this part.

1) A strangle:
A strangle is a form of a straddle, but unlike a straddle, the strikes of the calls and puts are different. For this example, I will buy a $60 put and a $90 call.

Because the strikes are away from the money, they are cheaper in time value premium. Thus, buying the combination will cost less than buying two ATM positions (the $75). Thus, the maximum loss is the cost of the call and put: $6+$17 = $23. However, to beat the spread and cash in, the options need to move
A) $23 higher than the $90 call, or
B) $23 lower than the $60 put.

This spread is harder to cover than a traditional straddle, and provides less reward. The blue line (Strategy #2) is a traditional straddle.

2) A Butterfly

A butterfly is the least risk strategy of the three for betting a move in the stock price, but offers the least upside. For a long butterfly, do the following:

1) Buy two ATM calls

2) Buy an ITM call

3) Sell an OTM call.

In this example, the net premium is the profit of the OTM ($60) and ITM ($90) calls minus the cost of buying the two ATM ($75) calls. $6+$17-2*$9=$5 net profit. 

However, if the stock price does not move, the $75 calls you bought will expire worthless, as is the call you sold at $90. The $60 call you sold is $15 in the money, so the buyer will exercise the call. Thus, your net profit of $5-$15 = -$10. A loss of $10 per share is the worse case for a butterfly.  The green line seen below is a butterfly.

• As the stock approaches $60, the $60 call will be less In the Money, which makes your profit rise (as you have less of a spread to cover)
• Once the stock moves below $60, all the calls will expire worthless, and you will profit the net $5 from the sale and buys of your calls.
• As the stock approaches $90, one of your $75 calls offsets the short $60 position, and the other $75 call will profit.
• If the stock moves above $90 - you can not profit even if the stock goes higher in value. Your short and long positions are canceled out, and the only profit is the net premium from selling the calls.

A question that arises with strangles: do I buy two OTM positions, ITM, or ATM? The answer: it doesn't matter (yes, I rounded).

The final warning: If volatility goes down, then both the calls and puts will lose money - even if the stock moves! These positions seem simple, but it is simple to see long positions expire worthless and the loss associated with the premiums.

What strike to buy?

I just talked to a British trader about Sirius radio. We discussed what option strategy to pursue if he believes the stock price will rise. Unfortunately, Sirius provided problems as an example because the strike prices were too close together and too small to truly show on my graph (premiums of a penny). So, I have picked Home Depot (HD) with the following information:


We believe the price will rise to $50 (so this is a Bullish spread). The question is: which option to buy?

As the strike price increases, the probability of the stock price reaching that price goes down. As such, we see the "time value" of the following options as the following:
 (there is rounding, which is why these numbers differ slightly)
Note there is no intrinsic value because these are out of the money calls.

The green line (strategy #1) is the $35 call, the blue line (strategy #2) is the $40 call and the $45 call is the red line (strategy $3)

Note that as each strategy becomes less risky, its upside reward lessens. Buying the $45 call is cheaper than buying the $35 call, but only earns $5 if the stock goes to $50. On the contrary, if you are wrong and the stock does not move, the $45 call has a max risk of $.05, where the $35 call risks $2.25
The $50 call is On the Money, so buying a $50 call would mean you would lose your $.03 ($3 total).

Well, what about buying an In the Money Call?

Here, we see an In the Money, At the Money, and Out of the Money compared: (notice that strategy #1 - the green line, is now an ITM call)

The ITM call has the best reward payoff, but the most downside risk. If you are wrong, and the option price falls to $25, the entire $10.5 you paid will now be lost. 

There are two more strategies that can not be over looked: a long position and selling a put.

Here is the following information for an At the Money Call and Put:

Selling a put allows you to gain if the stock moves, but you will lose the most from a drop in the price. The red line represents a traditional long strategy. The green line is our ATM call, though this could be exchanged with an OTM or ITM call depending on an investor's goals (as we discussed above)

Practice Trading Options

This is the site I use when I'm practicing trading. It's easy to use and doesn't require a fee:
http://www.cboe.com/tradtool/virtualtrade.aspx

Microsoft Excel Profit/Loss Diagram Uploaded!

I have uploaded the Microsoft Excel worksheet I used to learn option strategies.
I consider diagramming profit and loss a solid way to see different strategies. I have tried to create the simplest and most informative interface on the web.
Click the link on the left hand side of the screen. Please give me any feedback you have on it. 

A Basic Straddle

If you have a stock that you know is going to move, but unsure of the direction, options allow you the opportunity to profit with this mindset. I’ve been perplexed with LinkedIn (NYSE: LNKD) since its IPO. The fundamental question is: Is it the next Google ($500/share) and Apple ($320/share) or the next Yahoo ($14/share)? LinkedIn is currently trading at $75 per share. I believe it could either go down to $20, or all the way up to $120.

The simple answer using options is to peruse what is called a straddle. I will be using the FEB12 LNKD series.

The first, and most basic strategy is a straddle:

1)      Buy an ATM Put

2)      Buy an ATM Call

Reward: Unlimited on the upside, limited but substantial on the lower side. If the stock price goes up to $120, the put will expire worthless, and the call will be in ITM and exercised for a profit totaling $1100. If the stock goes to $20, the call will expire worthless and profit will be made on the put, earning a net $2100.

Risk: Limited. While this seems like a fool proof strategy (profit in an up or down market), the move that the market must make in order to profit is quite large. LNKD must move from $75 to either below $41 or above $109 to profit. If the bet is wrong, the potential profit loss is the cost of both options the 75C@15 and the 75P@19, or $3400 total.

Time erosion: Hurts position.

Increase in volatility: Helps position.

Another strategy will use equity in addition to options. By “marrying” stocks together with options, here is an example of strategy #2.

1)      Buy 50 shares of LKND

2)      Buy an ATM Put

Here we see one of the most fundamental rules of trading: less risk, less reward. The marrying strategy allows for less risk than a normal straddle. If the stock price remains unchained, the put will expire worthless, but I will still have my underlying stock. A traditional straddle, both the call and the put would expire worthless. However, any loss of value of the stock will increase the value of the put, but lower the value of the shares in your portfolio.

Neither strategy is “better” in an absolute sense. Both have the same risk/reward scenario, but in different ratios. Finally, many brokerage firms will allow you to buy a straddle as one item, paying commission only once. The marrying strategy is two separate trades, and commission will be taken as such.

In my next post, I’ll examine two more strategies that could be used given my beliefs about LinkedIn: a strangle and a butterfly.

Welcome!

After learning the basics of the options market, I was eager to use my newfound knowledge of options to create the various strategies I learned in my classes and the internet. However, I was very unimpressed with the current tools on the Internet. I felt there had to be an easier way to graphically depict potential profits and losses associated with options. So, I created my own. Using this tool created in Micrsoft Excel, I can easily plot various option strategies.

On this blog, I will explain some simple to intermediate level options strategies, using my program to graph strategies. I will not go very detailed into the delta, gama, vega, or rho’s of options, but stay more with the goals and risks of each strategy.