Sunday, December 13, 2015

Why does hedging work?

If you are a new reader and are confused about hedging stock, then this post is for you as I will explain the concept in broad terms why hedging works in the market. For more detail you can refer to the AAPL Update series where I have been actively hedging AAPL stock as an educational case study.

I opened a position of 600 shares of AAPL near the end of February 2015. At the time the stock was trading for 130 dollars per share for a total investment of 78 252.

Since then, the price of AAPL has declined and with the exception of a few brief periods the price has remained solidly under the 130 mark. The current price is trading for 113 per share.

This is a net loss against the original position. In percentage terms the price is down 13%. In dollar terms the position has an unrealized loss of $10 452. It's technically unrealized since I still hold the position — but I hope you realize the absurdity of that statement.

Okay, there have been two dividend payments since February which offsets this by just under $700, but that reduces the loss only to around $9700. Other than these dividend payments, no other contributions were made.

If you read the latest AAPL Updates you will know that the share count has increased to 749. At expiration, assuming the price remains around 113 the value of the position is 84 637 or an increase of 6385!

How did I accumulate nearly 150 more shares and swing the net P/L from a 9700 loss to nearly a 6400 profit? This is a difference of 15 800!

Can this even be possible?

How does hedging stock accomplish this?

You need to step back and understand what is happening with the collar position. There are two parts at work here: the stock and the options.

In simple terms the stock appreciates when the price goes up. In terms of measuring risk, we say the stock has positive deltas.

The collar or the hedge is made up of a combination of option instruments. These options carry negative deltas. When price moves down the hedge gains in value. We measure the risk on the collar by the amount of negative deltas.

The positive and negative deltas are always in opposition. Taken together, the stock deltas will always be greater, so we can say the position has a positive bias. This simply means that to make money, the stock must ultimately increase in price.

The interesting thing about hedging stock is that you are essentially playing both sides of the market. Rather than trying to predict market movement, you are just adjusting in response to it. The only thing you can be sure of is that stock will move up and will move down.

The trading part is the what you do when the price moves and the delta pieces begin to react. Taken together, both pieces are offsetting. So as price moves the gain in one offsets the loss in the other. It appears that the entire position in not changing in much in value. In fact, if you put on the collar piece and do nothing, you are losing opportunity. 

As price drops, we look to adjust or close hedges and capture profit from the collar. Depending how far the price moves, this may be small or quite large.

The profit from those hedges is recycled back into acquiring more stock. When the price begins to increase again, the net value of position increases because there is more stock.

When the price increases the hedges work against the stock price, but because of time decay those hedges will eventually expire leaving only the value of the stock.

Simply stated, when price moves up, profit is made on the stock. When the price moves down, profit is made on the collar. This profit is converted to cash and then into more stock.

The continual up and down movement of the stock generates income needed to purchase more stock which acts to reduce the overall cost basis of the position.

In the current case study, 749 shares divided into the original value of 78 252 is a per share value of 104.47. This is substantially lower than the 130.42 than the stock was originally hedged at.

Can the position lose money?

In a word yes. The collar is not without risk. But it has much much less risk than holding stock outright or even a covered call. The presence of the put ensures that during wild or catastrophic selling in price there is a defined maximum loss. Done properly, the collar absolutely limits the risk for the duration of the options expiration cycle.

If the stock goes into a prolonged and continued downtrend (ie: bankruptcy) without recovery, it is up to the trader to assess that fundamental risk and exit the trade as even the collar will begin to show a loss.

The best stocks for the collar are those that stable and with sideways to some upward bias — fundamentally strong and stable companies that are just subject to market movements. Stocks that can move at least 2-3 strike increments per month both directions are ideal.

In the markets nothing is for certain. However, this powerful strategy when executed correctly and with understanding of the mechanism behind it gives one confidence to build and maintain a portfolio.

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