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For Traders Only: Taking a Hedge From Defense to Offense


While married puts are good ways to protect profits, they aren't always the most effective use of cash once a position moves the wrong way.

The last month or so, I've written about how to hedge with long puts that act as a counterbalance against downward market movement. While most people understand that puts appreciate as the market goes down, it occurred to me that many might not know what to do with that put and the rest of the position as time is about to expire.

It's a little like, yes I have car insurance, but what do I do once there is an accident? The answer relies on how bad the accident is. When a car is totaled or wrecked the insurance kicks in and hopefully there is fair compensation to buy another vehicle. Sometimes the damage isn't all that significant, but will run more than the deductible so a claim is made. Other times the damage is just a ding and nothing is reported and any costs are taken out of pocket.

Owning beat-up stocks that are protected by a put (aka a married put) aren't so different from this example. Unfortunately, the choices aren't always so clear-cut.
Hedging is becoming a popular subject especially when the markets have shown us a propensity to insta-correct like days following the Egypt or Libya unrest.

Hedging isn't typically a short-term position. Not that it can't pay off quickly, but typically the disciplined hedger will keep him/herself protected with an ongoing counterbalance. Since recent moves haven't sustained any kind of extended downtrend, I'll go back to April through September of 2010 to illustrate when a married put went into the money. By that I mean, when the market dropped enough to get below the strike price of the protective put that would have been used as a hedge.

Starting Position

Let's start with a fictitious, but an effectively hedged position on the SPDR (SPY) established April 19, 2010.
  • Long 100 shares SPY @$119.8
  • Long 1 SEP10 113 Put for $3.6
    • Position Cost Basis: $123.4 ($119.8 + $3.6)
    • Max Loss of $10.4 (119.8-113+3.6) at $113
This gives us downside protection through September 17 if SPY was to fall below $113 which means our max loss is 8.4% ($10.4 / $123.4).

Fast-Forward Five Months

Now, let's fast forward to August 20, one month before the put expires. The SPY has dropped to $107.5 and during this time, the put has felt like a smart move. We were protected through the flash crash of May 6 and at the lows on July 2 when the SPY fell all the way to $102. On that day the put had risen to a value over $12.3. So while the SPY position experienced a 17.8 point decline, the put went up by $8.7. This illustrates the hedge has been working.

On August 20 with the SPY at 107.5, there is a decision to make. Our protection is in the money by $5.5 (113 strike - 107.5 market price) and is trading at $6.4 with four weeks to go. As a matter of regular practice we'll trade our puts out before they experience the rapid time decay of the last month. In other words, we have $0.90 ($6.4 - $5.5) of time value and there's no reason to waste that.

Here's where our car insurance analogy comes back into play. Have we dinged, damaged, or wrecked the car? Translation to market-speech: Has the position been totaled and gone past salvaging and do we need to get out of it altogether? Has the position taken some damage that we want to use the insurance to offset, but keep the underlying asset? Or is this just a blip and we're claiming the insurance money isn't worth the hassle?

Decision Time

The market helps us make some of these decisions. Since the put has increased in value there is some insurance money to take. We're not going to just ignore that $6.4 value. So clearly the car is more than dinged. A 10.2% ($119.8 to $107.5) decline in SPY should be a stinging reminder of this as well.

Choice 1: Close out entire position.

The first extreme is that we may think the car is totally wrecked so we dump the car and take the insurance money. That would mean selling the SPY stock and selling the put. This would net a loss of 8.8 points.
  • SPY loss of $12.3 ($107.5 - $119.8)
  • SPY Sep10 Put gain of $2.8 ($6.4 – $3.6)
  • Net loss of $9.5 or 7.7% ($9.5 / $123.4 org. cost basis)
Selling a loser can feel like the weight of the world lifted off our shoulders and we're ready to move on to a different investment choice. This investment didn't work out, but we were hedged and didn't take as big a hit to our portfolio as we could have if it followed the SPY down 10.2%

Choice 2: Just sell the profitable put.

If we are still bullish on the position, we could just sell the put for a $2.8 gain and stay long the stock. This would be like taking the insurance money and not fixing the car. Plenty of people do this, and it shows. However, our portfolio will be taking on more than curb-appeal risk. This act leaves us with an un-hedged position and we can potentially lose all 107.5 points. However, if the SPY goes to zero, we'll have bigger problems than brokerage account balances. Unfortunately, the unchecked risk remains and experiencing another 2008 is a possibility.
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No positions in stocks mentioned.
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