If an individual was considering:

  1. LONG 100 AAPL shares at 150
  2. SHORT 100 APPL shares at 150

How could he/she hedge the directional risk with options for those two trades? And what would be the outcome if options are used to hedge risk at the pre-determined strike price X

In addition, is there something one else one needs to know when considering hedging using options outside the aforementioned example?

  • I think this should probably belong to economics.SE – ssn Feb 5 '18 at 12:56
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    Your question starts out fine but becomes too broad. You can look up "delta hedging" to answer the first question, but there are many other factors, including volatility risk, gamma risk, dividends, interest rate risk, time decay, etc. – D Stanley Feb 5 '18 at 14:16
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    @ssn This isn't an economics question. Although the question does seem somewhat academic, questions about options trading and strategies are on topic here. – Chris W. Rea Feb 5 '18 at 14:26

Hedging long shares is the same process as hedging short shares. They are mirror images of each other. So let's stick to one side of the equation, LONG 100 shares. Some choices:

(1) Sell a COVERED CALL. This caps the gain and only provides a very limited hedge in the amount of the premium. If you sell an OTM 30 delta call, you're losing 70 cts per dollar drop and that rate of loss increases as the underlying drops. This is synthetically equivalent to a SHORT PUT so if not legging in, sell the put to save on frictional costs (B/A and commissions). R/R for a CC or SHORT PUT is lousy (limited profit, large potential loss).

(2) Buy protective puts. AAPL has a middling implied volatility so its options aren't cheap. One year ATM protection costs about 9% - more if an earlier expiration is used. That's a lot of drag to overcome. Be aware that LONG STOCK + LONG PUT is synthetically equal to a LONG CALL so same frictional cost issue as above. Downside is cost of put plus distance to strike (adjusted if ITM) and upside is anything AAPL appreciates less the cost of the put.

(3) COLLAR the shares. For every 100 shares, sell an OTM call and use the proceeds to buy an OTM put. This defines a floor beneath which you cannot lose as well as a ceiling, beyond which you do not profit (unless you roll the calls up and/or out).

Collars can be structured for a modest debit/cost. If you want to skew the risk graph to have more upside potential than downside risk, sell a call further OTM (debit collar). Skewing the collar in the opposite manner results in a net credit but the sale strike will be lower

If you do shorter term collars with a short call strike that is reasonably far enough OTM, there's a good chance that the stock will appreciate and not be taken away by assignment by expiry. If so, roll to a later month's collar at higher strikes. Wash, rinse, repeat. Caveat? Don't monkey with collars if you absolutely don't want to sell the stock.

A long stock COLLAR is synthetically equal to a VERTICAL SPREAD.

(4) Delta neutral hedge the position. If unfamiliar, Google it. This involves more hands on and requires a cooperative stock to succeed with (volatility).

Be aware that a dividend increase a put's price, relative to the call so if you are evaluating synthetics, make sure that you factor the dividend into any position that involves being long or short the underlying.

In the final analysis, it's all about finding an acceptable R/R spectrum that aligns with your outlook (hope?) for the underlying.

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