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stevesequities (38.35)

Reducing Risk Through Options

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February 12, 2013 – Comments (6) | RELATED TICKERS: AAPL , WFC , XLF


 I just watched the preview video for the new MF Pro, and it made me nervous. I'm a reletively new options investor. Most of my options trades involve selling covered calls for income, exiting a trade by surrendering over shares at a strike price higher than my cost basis per share, or, if it's Apple (APPL), pure speculation. Because options can potentially cost an investor 100% of their premium paid, or the surrendering of their shares, I try to approach them with a sure footing and extreme caution. With that perspective in mind, I was instantly nervous when the MF Pro team mentioned hedging an investment in Wells Fargo by buying a JAN 2014 put and selling a JAN 2014 call in the XLF. I have heard of buying a put in the bank that I own (in the video's case WFC) in the event that there is a short term correction in the stock price. But the video's plan involved writing a naked call to reduce risk. A naked call. And, they mention that if the XLF rises by 10-20% (the max they say), the amount of downside there isn't too bad. OK, so if I sell 5 Jan 2014 calls and use the proceeds to buy 5 Jan 2014 Puts, what would I risk if the XLF price exceeds my call's strike price? Well, if I'm correct here, 500 shares of the XLF (5 contracts), which I would have to buy in the open market since I don't own any (naked calls). So I would have to go out and pay around $10,000-ish only to give it away to someone for a lower price, giving me a downside in the neighborhood of a couple thousand dollars. Also, my put is worthless (most likely) if the price went up by that level, so I wouldn't gain anything from that. For me, a standard position would be around $15k, and I don't think 10k of exposure from an option position to hedge that position would be out of line. For all the readers out there, please tell me if my logic on that options trade is out of line. Did I miss something there when they said that the risk is substantially reduced by BUYING the jan2014 put and SELLING the jan2014 call? 

6 Comments – Post Your Own

#1) On February 12, 2013 at 11:20 PM, VExplorer (29.64) wrote:

I have not seen the video, but assume, the idea was create "enhanced" collar on WFC position (BUY PUT/SELL CALL). They just replaced one leg (SELL CALL on WFC) with another (SELL CALL on XLF) in line with their expectation WFC will outperform XLF. So, you can go step back to collar or step ahead (replace PUT on WFC with PUT on XLF). Or just short XLF to hedge long WFC position.

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#2) On February 12, 2013 at 11:28 PM, Speculatormaster (< 20) wrote:

Well I can only say you that my master teach me that naked calls is like a  kiss to the death (kiss of the death in simple words.) Beware!!!

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#3) On February 12, 2013 at 11:44 PM, shamapant (83.05) wrote:

Stevesequities,

 

it's not as risky as you seem to think it is, but it IS risky. They're essentially just saying that to hedge WFC, short the Financials ETF. They do this by using an options strategy that essentially mimics directly shorting a stock. Think about it.

 Buy 100 shares=buy 1 call SO (Short)Sell 100 shares=Sell 1 call.  It's literally an identical trade to short something and to sell a call on it. Risky? Yes because you have unlimited downside, but so does shorting a stock.

As to allocation, you would size it to your position. For example, if I want to hedge 100% of my position(Idk if you want to do that, i assume they'd make their own recommendation in the service) this is what you'd do: 

Own 100shares WFC? Sell 1 Call and Buy 1 Put with the proceeds. That ends up hedging your entire 100 shares. They say that your maximum downside in the stock is limited to the risk in the company(if the company goes bankrupt, you're screwed, but if all financials go bankrupt, you won't lose too much). Your maximum downside in the hedge, like they said, is likely only 10-20% b/c the underlying ETF will only move against you 10-20% and since you ended up only selling 1 call, your loss is limited to roughly 20% of your position in WFC. Of course theoretically you have unlimited potential loss if the financial ETF goes to infinity, but that's not going to happen because the financial ETF is made up of so many big banks that can't really grow too much more...I hope that helped? feel free to contact me at www.appraisalvalue.wordpress.com if you have anymore questions(I don't represent hte motley fool, just trying to be friendly).

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#4) On February 12, 2013 at 11:46 PM, shamapant (83.05) wrote:

An advantage to the strategy of selling a call and buying a put, vs. just shorting the stock is1) don't need to borrow shares, 2) don't have to pay monthly for expensive insurance by buying put options, 3) don't need to pay the 1.6% dividend yield of XLF that you'd have to pay if you shorted it.

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#5) On February 13, 2013 at 3:21 AM, Valyooo (99.41) wrote:

Buying stock + buying a put = synthetic call. Just buy a call in that case 

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#6) On February 13, 2013 at 10:10 AM, Teacherman1 (43.27) wrote:

shamapant-

I have added your blog site into my favorites, and look forward to checking in from time to time to see what you have to say.

That was a good explaination of how options work, but still not something this "Plain Vanilla" guy is interested in pursuing. I will leave that to the younger generation.:)

Good luck with your brokerage account. I assume you will be old enough to open one at that time.:)

By the way, did you notice that the CFO of Panera joined the board of ACPW? I'm curious about that.

Have a great week.

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