Question

Determine two to three (2-3) methods of using stocks and options to create a risk-free hedge portfolio can be created. Support your answer with examples of these methods being used to create a risk-free hedge portfolio.?

Answer 1

All portfolios contain risk due to market and changing economic conditions. Risk can benefit our portfolios greatly, and just as quickly it can be responsible for the majority of our losses. But, by using derivatives and certain investment vehicles, such as hedge funds, we can offset some of that risk and prevent losses in certain situations, while still maintaining upside exposure.

A simple exchange-traded option is the most versatile financial instrument available. There are different types of risk that an option can protect against: price differentials, the rate of change in those price differentials, interest rate changes, time and volatility. Most option strategies that protect against particular risks will be completed by using more than one option, such as an option spread.

Following are few option strategies that can be used to hedge portfolio :

1. Covered Calls:   A covered call is a risk-reducing strategy; in this, a call option is written (sold) against an existing stock position on a share-for-share basis. The call is said to be “covered” by the underlying stock, which could be delivered if the call option is exercised.This is a great way to create yield in your portfolio, though I will say it does not “hedge” you entirely. If the SPY were to drop dramatically, you would collect the premium taken in, but you would still be long the stock. It can be used to protect against relatively small price movements ad interim by providing the seller with the proceeds. The risk comes from the fact that in exchange for these proceeds, in particular circumstances, you are giving up at least some of your upside rewards to the buyer.

So for example, you own 1,000 shares of the XYZ, and therefore you are able to sell 10 calls against your stock so that you are covered.

For this theoretical exercise, I will look seven months out, and 3% out of the money. Based on this criteria, you could sell the September 159 calls for $3.40. If the XYZ stays below 159 by September expiration, you would collect $3,400, or a yield of 2.2%. If you do that twice a year, you would collect $6,800, or a yield of 4.4%.

You can choose any number of months or strikes. For instance, you can sell 5 September 159 calls and 5 December 161 calls. There are seemingly limitless amounts of calls you can sell, in many different combinations.

2. Put Purchase : Buying an option outright may not seem to be a measure to offset risk per se, but it can be when paired with the situation where a position contains a large on-paper profit. Instead of keeping the entire position invested, it can be divested, using a small portion of the proceeds to purchase put options. This strategy will act as a hedge against the potential downside risk of your originally invested capital. This strategy can also be viewed as offsetting opportunity risk. Theoretically, the cost of the option should be equal to this opportunity risk (as an option-pricing model may lead you to believe), but in more practical terms the cost of the option can often outweigh this opportunity risk and be beneficial to the investor.

Once again, assuming you own 1,000 shares of the XYZ, the truest hedge would be to buy 10 puts against it. If the XYZ were to drop below your puts strike price, you could simply exercise your puts, and you would be out of your entire stock position. The upside to this strategy is that you do not cap the potential profit if the XYZ price continues to rise.

For instance, you could buy 10 of the April 154 puts for $2.40. So if the XYZ were to drop below 154, you would exercise your puts, and you would be taken out of your XYZ stock position. However, you have to pay $2.40, or $2,400, for this insurance. Again, you can choose any number of strikes and time frames for this strategy.

3. Offsetting Price Risk: To offset a position's price risk, one can create an option position with a delta inversely equivalent to the position at hand. By definition, the equity has a delta of one per unit, so the position's delta is therefore equivalent to the number of shares. An investor can sell a particular number of calls (some naked) to offset the delta because the delta of a call sold is negative. This does come with some risk, as selling naked calls has potentially unlimited liability. This is a more sophisticated strategy, but is a truer hedge to your portfolio than a covered call. You must be able to trade spreads in order to execute a Risk Reversal.

In this example, you will be selling a call that is out of the money and buying a put that is out of the money. This is a strategy that will reduce the capital that you have to pay for your hedge, but it limits your upside.

Once again, assuming you own 1,000 shares of the XYZ, you could sell the April 159 call for $0.50 and buy the April 154 put for $2.40. In this case, your capital outlay is only $1.90, whereas in the put purchase above, you were paying $2.40.

So let’s break down the various scenarios of this trade. If the XYZ were to go below 154, you could exercise your puts and get out of your stock position. On the other hand, if the XYZ were to rally above 159, you would be taken out of your stock position by the holder of your short call. If the XYZ were to stay between 154 and 159, the position would expire worthless and you would be out the $1.90 that you paid for this position.

Conclusion : You can use any of these strategies against any of your equity or index holdings.