American Investment Training

Tuesday, April 3, 2018

Stock and Option Hedging Strategies - Stock and covered call writing for Series 7 Exam Study

Covered call writing with an existing long stock position is a popular hedging strategy that investors and brokers-in-training should know. It is an income strategy, and it lowers your cost on your main (long stock position) because of the premium you receive for selling (shorting/writing) the contract. 

Let's look at a covered call with Stock Example

Mr. Bonds owns 100 shares of HPK at $72 a share. HPK has been fairly stagnant recently, trading between 71 and 74. It has yet to breakthrough $75, but Mr. Bonds feels the stock has great potential to rise considerably in 3-6 months, so he does not want to sell it. How can he profit from this prediction?   One way is to sell (write) a call option contract on HPK to receive income. These contracts have monthly expiration dates, with the longer term expirations costing more money. 

He decides to initiate writing a covered call. It is called "covered" because he owns the stock that the call options is based on. If the call options is exercised, Mr. Bond will have to deliver (sell) his 100 shares to the call holder at a specific price set in the contract. This is called the strike price. If the call option does not get exercised and expires worthless - Mr. Bond keeps the premium he received for selling the option, and retains ownership in the stock. This is the best case scenario for an investor who writes call options on a long stock position. 

It is best explained by laying out a complete position - and the hedge. 

LONG 100 SHARES HPK@ $72 
SHORT 1 HPK JUL 75 CALL@3

Breakdown of the call option contract:

Each option contract represents 100 shares of stock. They also expire monthly. So this one expires in July. Whatever decision the investor makes, he must decide before the contract expires towards the end of July. Each contract carries a "premium" based on 100 shares. This contract is $300. That amount is what the buyer would pay to own the contract, and what the seller (writer) receives for shorting the contract. Each person betting on different directions of the stock. 

For Mr. Bond, he is shorting the call option hoping the stock stays stable and the option is expires. He keeps the $300 premium, which now lowers his cost on his stock to 69. He can continue to write calls periodically, and if he is successful - his cost (and break even) can be lowered even more. So YES!, you can make money on a sleepy stock. 

The maximum GAIN on this strategy (while both positions stay) is $600. If the stock rises enough to trigger the option, the investor MUST sell the shares at 75. He paid 72, and he also collected $300. 3 points on the stock and 3 on the premium = $600

What is the downside?  There always is a downside.....

The main downside is the stock itself drops big, and the contract expires.You lose in share price on your stock, and the contract is now gone. The lesser risk is the stock rises before July which triggers the option, and Mr. Bond has to sell his stock at 75. He still makes money, but if the stock continues to shoot up - the investor will miss out on it, as he no longer owns the stock itself. 

The Maximum LOSS is $6900.  If the stock drops to ZERO, the share value can all be lost - the $300 premium which he always keeps. 

The Breakeven is 69.  The breakeven on these positions is always the cost of the stock minus the premium received. He is profitable until the stock hits 69.

The best case scenario is the stock stays stable or within a thin trading range, the premium is kept, the option expires, and then at a later date - the stock jumps up strong for unlimited gains in the future.

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