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Minyan Mailbag: A Simple Question on Options

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Minyans ask...professors answer

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The following question was answered by Professors John Succo and Adam Warner

Professors,

I would like to ask a simple question in regard to hedging that I think most people have thought about once or twice, but most do not understand the "how to" mechanics.

Suppose you have 1000 shares of Cisco Systems (CSCO) which is at a resistant level of 22. You decide it would be prudent to buy an OCT PUT at 20 instead of selling shares (due to low basis). How does one calculate the appropriate number of put options to protect his CSCO shares?

Thanks,
Minyan Christian


MC,

To protect 1000 shares with a deductible to 20 just buy 10 puts so it is one up against long stock. If you want to "delta" hedge it so that each loss in the stock is protected one for one with gains in the puts, simply divide 1000 shares by the delta. If the delta starts out at 0.2, this means buy 10/0.2 = 50 puts. But when you do this it assumes you will constantly adjust this delta as the stock moves around. This can be very costly for the average investor. This is why I advise non-professionals to use option only strategically, as in the first case.

-Succo


MC,

There are a few ways to go about this.

To truly neutralize using Oct 20 puts, you would have to buy an amount that equals 1000 shares of share equivalency. With a 14 delta, that comes out to about 71 puts. At 20 cents, that comes out to nearly $1500, meaning that CSCO basically has to go up another $1.50 before you start earning on the upside again.

But there are other approaches.

You could simply buy 10, and effectively stop yourself out should the stock go back under $20.

You could replace your stock with Oct 20 calls, again stopping out below $20, and *untying* some capital. This of course may not work in cases where the stock sale has tax implications.

But the best idea in my humble opinion, IF you are interested in really locking in the gain, is to purchase 10 Oct 22.5 puts. It would actually cost less money than delta hedging with the Oct 20 puts (they are quoted 90 cent bid, $1 offfer), and you effectively stop out your long at $21.50.

-Adam


Read more about options in Professor Succo's excellent Options Tutorial.
No positions in stocks mentioned.

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