If you lie awake at nights fretting about your market positions, the chances are that you’ve lost control. This article will explain how the use of “option spreads” can help you sleep at night. You must define the risk with which you are comfortable and hedge accordingly to remain in control.
You control your own wins and losses – Maria Sharipova
The indispensability of Option Spreads
I’ve decided that the utility of options spreads is best illustrated with a live example from the time of writing.
Recently, Twitter (the social media short messaging platform) has struggled to demonstrate its ability to monetize its audience sufficiently to satisfy investors. As a result, the stock is trading at around $29, an all time low since flotation.
NB: This article is not endorsing Twitter options nor shares as an investment vehicle, I’m using it only for illustrative purposes; all the prices are accurate at the time of publication.
You believe the price has stabilized and decide you will sell 10 monthly Put option contracts at a strike of $28 for a premium $1.05.
Let’s just review what that means. Each “contract” in US equity options represents 100 shares of the stock. You are agreeing to buy 10 contracts’ worth of Twitter stock (1,000 shares) should the price fall below $28. In exchange, you receive a cash premium of $1.05 per share or $1,050 (this appears in your trading account immediately).
If Twitter remains at or above $28 at the end of one month, you’ve made $1,050.
But if Twitter falls to zero, you’ve lost $26,950 ($28,000 – $1,050). However unlikely you think this is, it’s not advisable to enter into such a one-side trade.
Now on to the spread as a hedge; but before we do, let’s put a marker down on the un-hedged position; if Twitter stays above $28, you’ve made $1,050 or approximately 3.75% on Capital at Risk ($27K).
The good thing about options is, that there are plenty of options. What if instead of just selling Puts, we notice that the $26 Put for the month was trading at 48c. If you purchase that Put, then somebody else would be committed to buying the stock from you if it fell to below $26.
Your position would be “hedged“.
So instead, you sell the $28 for $1.05 and purchase the $26 for 48c, leaving a net premium of 57c. (You can do this simultaneously on most trading platforms).
Capital at Risk
No longer are you exposed to a total collapse in the stock price, your exposure is the difference between 1,000 shares at $28 and 1,000 shares at $26 less your net premium of 1,000 x 57c or:
($28,000 – $26,000) less $570 = $1,430.
So you will receive a net premium of $570 instead of $1,050 but your return on Capital at Risk is now $570/$1,430 x 100 or 40%.
Have a good night’s sleep.
© The Naked Putz 2015