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Hedging for Disaster - Introduction

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Hedging for Disaster


Introduction
It is possible to lessen potential losses by buying a deep out-of-the-money LEAP put at the same time the primary, near-the-money LEAP put is sold. This type of hedging strategy is particularly useful if you are going to sell LEAP puts on lower-rated companies or on stocks known to be highly volatile. What this does is reduce potential profits while simultaneously reducing potential loss. Profit is reduced because the net premium generated is the difference between the premium received from the sale of the higher-strike LEAP put and the premium paid for the purchase of the lower-strike LEAP put.*
On the other hand, the maximum amount of financial exposure is reduced from that of the strike price of the LEAP put sold to that of the difference between the two strike prices involved. Should the stock price fall below the strike price of the insurance put, the incremental financial exposure on the primary put is exactly counterbalanced by the incremental inc…