Hedging is a very savvy move that may seem boring, but in fact can be a lifesaver. This financial maneuver involves controlling and limiting losses. The classic example involves being long a stock that has a chance of declining and giving disastrous losses to the investor. To protect against large losses, the investor may, for a time, hedge with a put option. Trust and believe that your portfolio will thank you. Here we will go over some key concepts to know when adding hedge contracts to your investments.
In or Out of the Money
Hedges have a specified price, often called a strike price for a specified security, which serves as the boundary between the hedge becoming useful vs. useless. If the hedge, typically an option or futures contract, is not profitable, it is “out of the money.” If the hedge becomes profitable, it is “in the money.” When hedge strike price and market price of the underlying security match, the hedge is “at the money.”
Derivatives like options and futures are subject to time decay. Time decay is a fact of life when a financial contract has an expiration date. A time decay curve will illustrate that the time-value of an option will sink gradually at first, and accelerate downwards as the expiration date nears. This is important in deciding what to do with derivatives trades that have not closed and are close to expiration date.
Assume that you purchased 1000 shares of stock XYZ at 20 dollars/share that has grown to $35. Right now, that would be a $15,000 paper gain; pretty impressive but economic clouds are on the horizon. You could cash out, but forego further possible gains; imagine if XYZ goes to $55 right after you sell. Aside from flat-out risking the entire $35,000 investment, buying 10 put options with a strike price of $32, would provide peace of mind. Let’s say that the pessimism is justified and shortly after the put options are purchased, XYZ tanks to $12/share.
You now have the good fortune of having several profitable choices thanks to your hedge:
exercise the puts and lock in $12,000 in gains
sell the puts and funnel profits into XYZ stock at $12/share, thereby lowering cost basis
sell the puts as well as the underlying stock and seek out other investments
The decision to sell or exercise any hedge agreement subject to time decay will depend on how close to expiration date it is. Typically, sale of an option is preferred if the hedge becomes profitable quickly. Drawing out the trade and hoping for a greater gain later risks time decay that is more and more likely to negate hedge protection altogether. When an option is in the money and getting close to expiration date, exercising the option is better.
There are many ways to stack hedges to reduce risk, lock in profits, or to compensate one loss with another gain. This activity is often contrasted with speculation, though the difference between the two is not categorical. Speculation is similar to gambling in that the trader hopes for a long-shot trade that will fail most of the time, but returns spectacular returns on the odd chance it succeeds. Hedging presupposes ownership already worth something and seeks to either limit direct losses or settle for smaller profits in exchange for cost of the hedge contracts.
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