Monday, December 17, 2007

Option FAQ, Part 2: Hedge it to Me!

Last week, I began this Option FAQ with a basic introduction to options. In part 2, I will delve more into more advanced hedging functions.

The first hedging function I discussed last week was to put a floor on stock value by buying a put option. Now let's consider the reverse, selling a put.

Selling a put means you are providing someone the option to have their stock purchased from them, by you. This is the opposite of buying a put, and is similar to shorting any given stock (including requiring margin). What does this look like?

This chart is the mirror image from the basic introduction image. Blue represents the stock price, while the red line represents a Jan '08 Put Option @ $700 that you have sold while you hold Google stock.

As the graph shows, by selling a put option, you have created a ceiling for your portfolio.

Now lets talk about call options.

Call options provide the ability to buy an underlying equity. If you buy a call, you are purchasing the right to buy an equity at the specified price. If you sell a call, you are selling the right to buy from you an equity at a specific price. So what do calls and stock look like for your portfolio? I'm going to teach you to work it out for your self with fancy term called "Financial Engineering".

Technically, this is the design of various financial products that decrease external risk, and help you get a financial instrument with the exact risk you are looking for. As applied to options, this is like putting puzzles together.

Let me decompose those portfolio value charts that I have made, and provide you with what each option type actually looks like:

Now you've seen me combine stocks with the put options for portfolio value, so I will walk you through a combo stock + sell call. Remember a stock follows a diagonal line. So let's put these two lines onto one graph.

(Due to spacing issues, the graph I'm referring to may be lower on the page) The blue line is Google stock, the red line is the option, and the purple line represents the combination of the two. As you can see, prior to hitting the strike price, a combination portfolio has more value than the stock, primarily because of the money received for the sell of the option.

Past the strike price point ($700), the portfolio value flattens, while the components head in different directions.

This is the basis of a hedge. You want two instruments that move in exact opposite directions.

Now go out there and play with each of the four option possibilities, and we'll discuss the tried and true options combinations.

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