Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
CATHY WOOD ARK GARBAGE ARK Funds Heading for 90% STOCK CRASH! - 22nd Jan 22
Gold Is the Belle of the Ball. Will Its Dance Turn Bearish? - 22nd Jan 22
Best Neighborhoods to Buy Real Estate in San Diego - 22nd Jan 22
Stock Market January PANIC AI Tech Stocks Buying Opp - Trend Forecast 2022 - 21st Jan 21
How to Get Rich in the MetaVerse - 20th Jan 21
Should you Buy Payment Disruptor Stocks in 2022? - 20th Jan 21
2022 the Year of Smart devices, Electric Vehicles, and AI Startups - 20th Jan 21
Oil Markets More Animated by Geopolitics, Supply, and Demand - 20th Jan 21
WARNING - AI STOCK MARKET CRASH / BEAR SWITCH TRIGGERED! - 19th Jan 22
Fake It Till You Make It: Will Silver’s Motto Work on Gold? - 19th Jan 22
Crude Oil Smashing Stocks - 19th Jan 22
US Stagflation: The Global Risk of 2022 - 19th Jan 22
Stock Market Trend Forecast Early 2022 - Tech Growth Value Stocks Rotation - 18th Jan 22
Stock Market Sentiment Speaks: Are We Setting Up For A 'Mini-Crash'? - 18th Jan 22
Mobile Sports Betting is on a rise: Here’s why - 18th Jan 22
Exponential AI Stocks Mega-trend - 17th Jan 22
THE NEXT BITCOIN - 17th Jan 22
Gold Price Predictions for 2022 - 17th Jan 22
How Do Debt Relief Services Work To Reduce The Amount You Owe? - 17th Jan 22
RIVIAN IPO Illustrates We are in the Mother of all Stock Market Bubbles - 16th Jan 22
All Market Eyes on Copper - 16th Jan 22
The US Dollar Had a Slip-Up, but Gold Turned a Blind Eye to It - 16th Jan 22
A Stock Market Top for the Ages - 16th Jan 22
FREETRADE - Stock Investing Platform, the Good, Bad and Ugly Review, Free Shares, Cancelled Orders - 15th Jan 22
WD 14tb My Book External Drive Unboxing, Testing and Benchmark Performance Amazon Buy Review - 15th Jan 22
Toyland Ferris Wheel Birthday Fun at Gulliver's Rother Valley UK Theme Park 2022 - 15th Jan 22
What You Should Know About a TailoredPay High Risk Merchant Account - 15th Jan 22
Best Metaverse Tech Stocks Investing for 2022 and Beyond - 14th Jan 22
Gold Price Lagging Inflation - 14th Jan 22
Get Your Startup Idea Up And Running With These 7 Tips - 14th Jan 22
What Happens When Your Flight Gets Cancelled in the UK? - 14th Jan 22
How to Profit from 2022’s Biggest Trend Reversal - 11th Jan 22
Stock Market Sentiment Speaks: Are We Ready To Drop To 4400SPX? - 11th Jan 22
What's the Role of an Affiliate Marketer? - 11th Jan 22
Essential Things To Know Before You Set Up A Limited Liability Company - 11th Jan 22
NVIDIA THE KING OF THE METAVERSE! - 10th Jan 22
Fiscal and Monetary Cliffs Have Arrived - 10th Jan 22
The Meteoric Rise of Investing in Trading Cards - 10th Jan 22
IBM The REAL Quantum Metaverse STOCK! - 9th Jan 22
WARNING Failing NVME2 M2 SSD Drives Can Prevent Systems From Booting - Corsair MP600 - 9th Jan 22
The Fed’s inflated cake and a ‘quant’ of history - 9th Jan 22
NVME M2 SSD FAILURE WARNING Signs - Corsair MP600 1tb Drive - 9th Jan 22
Meadowhall Sheffield Christmas Lights 2021 Shopping - Before the Switch on - 9th Jan 22
How Does Insurance Work In Europe? Find Out Here - 9th Jan 22
MATTERPORT (MTTR) - DIGITIZING THE REAL WORLD - METAVERSE INVESTING 2022 - 7th Jan 22
Effect of Deflation On The Gold Price - 7th Jan 22
Stock Market 2022 Requires Different Strategies For Traders/Investors - 7th Jan 22
Old Man Winter Will Stimulate Natural Gas and Heating Oil Demand - 7th Jan 22
Is The Lazy Stock Market Bull Strategy Worth Considering? - 7th Jan 22
METAVERSE - NEW LIFE FOR SONY AGEING GAMING GIANT? - 6th Jan 2022
What Elliott Waves Show for Asia Pacific Stock and Financial Markets 2022 - 6th Jan 2022
Why You Should Register Your Company - 6th Jan 2022
4 Ways to Invest in Silver for 2022 - 6th Jan 2022
UNITY (U) - Metaverse Stock Analysis Investing for 2022 and Beyond - 5th Jan 2022
Stock Market Staving Off Risk-Off - 5th Jan 2022
Gold and Silver Still Hungover After New Year’s Eve - 5th Jan 2022
S&P 500 In an Uncharted Territory, But Is Sky the Limit? - 5th Jan 2022

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

How to Use Options to Hedge Against a Stock Market Correction

Stock-Markets / Options & Warrants Mar 13, 2012 - 08:21 AM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleLarry D. Spears writes: Stocks have been mostly higher the past five months, with the Dow Jones Industrial Average recently topping 13,000 for a few days and the Nasdaq Composite touching the key 3,000 mark on the final day of February.

However, the markets have turned erratic the last week or so, and big moves like last Tuesday's plunge have left many investors to worry about a looming stock market correction.


Normally, that would send options-savvy investors in search of protective puts so they could lock in profits on their long stock positions.

In doing so they essentially are buying an "insurance policy" that would pay off should prices indeed turn lower in the next couple of months.

But, as readers who checked out Money Morning writer Don Miller's Wednesday article on the VIX Indicator, which measures trading activity in options on the Standard &Poor's 500 index - and, by association, options on individual stocks comprising the major indices - last week's jump in volatility sent put prices sharply higher.

In fact, the VIX Indicator itself jumped from just 16.83 on Feb. 23 to a reading of 20.84 on Tuesday.

And, though it has pulled back a bit since, the volatility means merely buying protective puts at this time would be a fairly costly proposition.

As an example, assume you hold 100 shares of stock in Las Vegas Sands Corp. (NYSE: LVS), having happily watched as the market's rally carried its price from an Oct. 3, 2011, level of $36.71 to a March 1 high of $56.82.

However, the $3.33 decline by LVS last Monday and Tuesday leaves you little doubt the stock would be vulnerable in any upcoming stock market correction.

And even though the stock rebounded to $55.29 by Thursday's close, you still feel like you need a little protection for your paper profits.

So, what do you do?

How to Protect Yourself Against a Stock Market Correction
As noted above, the first inclination is to look at the purchase of a protective put option.

But, because of the increased volatility, put premiums have risen sharply. To be precise, the at-the-money June $55.00 LVS put, which expires on June 16, was quoted late Thursday at $4.28 a share - or $428 for the full 100-share contract.

At that put premium, the price of Las Vegas Sands stock would have to fall to $50.72 ($55.00 - $4.28 = $50.72) before you'd get any protection, meaning you'd give back $457 of your present gains. The cost of the hedging put would also offset any additional gains on LVS stock up to a price of $59.57 ($55.29 + $4.28 = $59.57).

Not the most effective insurance policy by any means.

But, fortunately, there's a more attractive - and far less costly - alternative.

It's a triple-pronged hedge that still involves buying a protective at-the-money June $55 put, but offsets the cost - and greatly lowers the risk - through the simultaneous sale of both an out-of-the-money LVS put and an out-of-the-money LVS call option.

Sale of the second put - in this case, a June $50 put - creates a bearish spread that will insure your LVS position, almost completely offsetting any drop in the price of the underlying shares to that strike price level.

The sale of the call - in this instance, a June call with a $60 strike price - brings in enough added money to offset most or all of the cost of the put you buy for protection.

And, as a bonus, it also allows you to pick up a limited amount of additional profit should your concerns prove unfounded and the LVS stock price continue to rise.

This combination carries no additional margin requirement because the stock you hold covers the call you sell, and the at-the-money put you buy as insurance covers the put you sell.

Breaking Down this Three-pronged Hedge
To clarify, let's look at some actual numbers, based on Las Vegas Sands option prices available shortly before the close last Thursday, when you could have:

•Purchased the June $55 LVS put at $4.28, or $428 for the full 100-share contract;
•Sold the June $50 LVS put at $2.28, or $228; and,
•Sold the June $60 LVS call at $2.19, or $219.
Those three transactions would have actually given you a small net credit of $19 ($2.28 + $2.19 - $4.28 = $0.19, or $19), plus you'd have created a three-pronged hedge that:

•Locked in all but $10 of your current paper profit at any LVS stock price from the current level down to the $50 strike price of the put you sold;
•Reduced your potential loss to less than half the loss on the stock itself should the LVS price drop below $50 a share;
•Allowed you to add up to $490 in additional profits - slightly more than on the stock alone - if your concerns proved wrong and LVS rallied again, climbing to $60 a share. (Your additional profit would be limited to $490 since losses on the call you sold would offset gains on the stock at any LVS price above $60 a share.)

To clarify these advantages, the accompanying table shows all the possible outcomes for this strategy at any Las Vegas Sands Corp. price between $45 and $65 per share (assuming the positions are held until the option expiration on Friday, June 16, 2012).

Picture of a Triple-Pronged Option Hedge
The table below shows the possible outcomes for a triple-pronged hedge position on Las Vegas Sands Corp. at various stock prices on June 16, 2012. The analysis uses the example of a 100-share lot of stock and single June put and call options, all priced at late-day levels on Thursday, March 8, when LVS was trading at $55.29 a share.

This hedging strategy will work equally well with almost any stock priced above $20 a share. It also works across differing time frames, though the amount of downside protection on shorter-term hedges will be reduced by the smaller time premiums for the options.

Obviously, if your concerns prove to be unfounded and the stock you're hedging resumes its upward course, this strategy will limit your future profits (unless you buy back the call you sold). However, if you have gains on an existing position, this strategy can be a highly effective means of protecting yourself.

And, depending on the strike prices and premiums of the out-of-the-money options you choose to sell, you can protect your gains against a stock market correction at little or no cost.

Source http://moneymorning.com/2012/03/13/how-to-use-options-to-hedge-against-a-stock-market-correction/

Money Morning/The Money Map Report

©2012 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in