Showing posts with label principles-of-hedging. Show all posts
Showing posts with label principles-of-hedging. Show all posts

Hedging for Disaster - Introduction

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 increase in value of the insurance put. For example, suppose you sold an at-the-money LEAP put on a $100 stock with a volatility 0.50 and with 24 months till expiration. 

You would expect to receive a contract premium of $2,077.40 for it. Suppose now that you had simultaneously purchased a LEAP put with strike price of $85 on the same stock with the same expiration date. As indicated in Table A.8, you would expect to pay $1,374.10 for it. Your net premium is therefore $2,077.40 less $1,374.10, or $703.30. On the other hand, the maximum financial exposure is limited to $15 a share, or $1,500 per contract, no matter how low the price of the underlying issue at expiration.

Procedure

For analysis purposes, suppose the strike price of the insurance put to be three steps below the strike price of the primary, at-the-money put. To what extent is the purchase of such disaster insurance worth it? To answer this question, I repeat Runs No. 1 through 4 but where, for each at-the-money LEAP put sold, a corresponding LEAP put three steps out of the money is simultaneously purchased for insurance purposes. If the primary at-the-money LEAP put sold winds up out of the money at expiration, the net profit is the premium received on the at-the-money put less the price paid for the lower-strike insurance put. 

If the at-the-money LEAP put winds up in the money but above the strike price of the insurance put, the net profit or loss is calculated as the net premium received on the at-the-money LEAP and insurance puts less the financial exposure incurred at expiration on the at-the-money LEAP put. If the stock price at expiration is below the strike price of the insurance put, the overall financial exposure is the difference between the two strike prices involved offset by net premium received on the at-the-money LEAP and insurance puts.

The Full Universe

Run No. 23 shows the effect of taking the full universe of 217 stocks considered in Run No. 1 and combining the same set of LEAP puts sold with the purchase of insurance puts at a strike price three steps out of the money. By comparing, we see that the premiums collected on expired LEAPS have fallen from $8,354,277 to $6,494,411, with the difference of $1,859,866 being the cost of the insurance puts purchased. On the other hand, the financial exposure from puts expiring in the money falls from $5,619,931 to $4,325,249, a reduction of $1,294,682. 

Of the 39,405 expired LEAP contracts, 8,770 expired in the money, and it turns out that in just 2,541 of these instances was the stock price at expiration below the strike price of the insurance put. What the computer simulation thus revealed was that in only 2,541 instances out of 39,405 expired LEAPS (6.4 percent) was the insurance protection of any value. The retention rate barely increased from 42.6 percent in Run No. 1 to 43.1 percent in Run No. 23, while the account value at the end of the ten-year period barely increased from 44.3 percent in Run No. 1 to 44.9 percent in Run No. 23.

The B Minimum Universe

Run No. 24 shows the effect of taking the B minimum universe of 178 stocks considered in Run No. 2 and combining the same set of LEAP puts sold with the purchase of insurance puts at a strike price three steps out of the money. By comparing, we see that the premiums collected on expired LEAPS have fallen from $6,803,725 to $5,334,626, with the difference of $1,469,099 being the cost of the insurance puts purchased. On the other hand, the financial exposure from puts expiring in the money falls from $3,779,739 to $3,043,533, a reduction of $736,206. 

Of the 33,312 expired LEAP contracts, 6,667 expired in the money, and in just 1,851 of these instances was the stock price at expiration below the strike price of the insurance put. Thus, in only 1,851 instances out of 33,312 expired LEAPS (5.6 percent) was the insurance protection of any value. The retention rate decreased from 54.3 percent in Run No. 2 to 52.7 percent in Run No. 24, while the account value at the end of the ten-year period decreased from 57.5 percent in Run No. 2 to 55.2 percent in Run No. 24.

The B+ Minimum Universe

Run No. 25 shows the effect of taking the B+ minimum universe of 115 stocks considered in Run No. 3 and combining the same set of LEAP puts sold with the purchase of insurance puts at a strike price three steps out of the money. By comparing, we see that the premiums collected on expired LEAPS have fallen from $3,992,382 to $3,205,536, with the difference of $786,846 being the cost of the insurance puts purchased. On the other hand, the financial exposure from puts expiring in the money falls from $1,742,423 to $1,449,616, a reduction of $292,807. 

Of the 21,858 expired LEAP contracts, 3,504 expired in the money, and in just 798 of these instances was the stock price at expiration below the strike price of the insurance put. Thus, in only 798 instances out of 21,858 expired LEAPS (3.7 percent) was the insurance protection of any value. The retention rate decreased from 66.2 percent in Run No. 3 to 64.5 percent in Run No. 25, while the account value at the end of the ten-year period decreased from 69.7 percent in Run No. 3 to 67.4 percent in Run No. 25.

The A- Minimum Universe

Run No. 26 shows the effect of taking the A- minimum universe of 50 stocks considered in Run No. 4 and combining the same set of LEAP puts sold with the purchase of insurance puts at a strike price three steps out of the money. By comparing, we see that the premiums collected on expired LEAPS have fallen from $1,440,155 to $1,201,730, with the difference of $238,425 being the cost of the insurance puts purchased. On the other hand, the financial exposure from puts expiring in the money falls from $431,447 to $400,194, a reduction of $31,252. 

Of the 10,018 expired LEAP contracts, 1,291 expired in the money, and in just 261 of these instances it turns out, was the stock price at expiration below the strike price of the insurance put. Thus, in only 261 instances out of 10,018 expired LEAPS (2.6 percent) was the insurance protection of any value. The retention rate decreased from 79.9 percent in Run No. 4 to 76.5 percent in Run No. 26, while the account value at the end of the ten-year period decreased from 84.9 percent in Run No. 4 to 80.3 percent in Run No. 26.

RUN NUMBER 23

ATM Strike Price Is the High, Low, or Closing Stock Price:                         C
No. of Steps LEAP Written Put Is below ATM Strike Price:                         0
No. of Steps LEAP Offset Put Is below ATM Strike Price:                             3
Minimum No. of Months till Expiration:                                                          8
Premium Reinvestment Rate:                                                                              6.0%
Minimum First Call Rating:                                                                                  5.0
Minimum Standard & Poor's Rating:                                                                 None
No. of Stocks Meeting Either Criterion:                                                             217

Table  LEAP OTM and ITM Rates


Table  Premiums Collected and Realized Gain for Expired LEAPS


Table  Premiums Collected and Unrealized Gain on Active LEAPS


Table  Premiums Collected and Account Values


RUN NUMBER 24

ATM Strike Price Is the High, Low, or Closing Stock Price:                          C
No. of Steps LEAP Written Put Is below ATM Strike Price:                          0
No. of Steps LEAP Offset Put Is below ATM Strike Price:                              3
Minimum No. of Months till Expiration:                                                           8
Premium Reinvestment Rate:                                                                              6.0%
Minimum First Call Rating:                                                                                  2.0
Minimum Standard & Poor's Rating:                                                                 B 
No. of Stocks Meeting Either Criterion:                                                             178

Table LEAP OTM and ITM Rates


Table  Premiums Collected and Realized Gain for Expired LEAPS


Table  Premiums Collected and Unrealized Gain on Active LEAPS


Table  Premiums Collected and Account Values


RUN NUMBER 25

ATM Strike Price Is the High, Low, or Closing Stock Price:                          C
No. of Steps LEAP Written Put Is below ATM Strike Price:                          0
No. of Steps LEAP Offset Put Is below ATM Strike Price:                              3
Minimum No. of Months till Expiration:                                                           8
Premium Reinvestment Rate:                                                                              6.0%
Minimum First Call Rating:                                                                                  1.6
Minimum Standard & Poor's Rating:                                                                  B+
No. of Stocks Meeting Either Criterion:                                                             115

Table  LEAP OTM and ITM Rates


Table  Premiums Collected and Realized Gain for Expired LEAPS


Table  Premiums Collected and Unrealized Gain on Active LEAPS


Table  Premiums Collected and Account Values

RUN NUMBER 26

ATM Strike Price Is the High, Low, or Closing Stock Price:                              C
No. of Steps LEAP Written Put Is below ATM Strike Price:                              0
No. of Steps LEAP Offset Put Is below ATM Strike Price:                                  3
Minimum No. of Months till Expiration:                                                               8
Premium Reinvestment Rate:                                                                                   6.0%
Minimum First Call Rating:                                                                                       1.2
Minimum Standard & Poor's Rating:                                                                      A-
No. of Stocks Meeting Either Criterion:                                                                  50

Table  LEAP OTM and ITM Rates


Table  Premiums Collected and Realized Gain for Expired LEAPS


Table  Premiums Collected and Unrealized Gain on Active LEAPS

Table  Premiums Collected and Account Values


Conclusions

Historically, it would appear that the use of insurance puts to hedge against market downturns is not a cost-effective strategy when dealing with highly rated stocks, and
over the long run, it appears to be only marginally beneficial for lesser-quality issues. As a result of this analysis and my own experience, I have never bought protective puts as a hedge against LEAP puts written on high-quality companies rated B+ and above. In the short run, it is entirely possible for market prices to drop below exercise prices (this has happened to me on numerous occasions), but in such instances I prefer to use rollout techniques as my primary recovery-and-repair strategy.

I sidestep the issue of whether or not to buy insurance puts on stocks rated B and below by ordinarily not writing LEAP puts on such lesser-quality issues in the first place. On those (few) occasions that I elect to sell LEAP puts on lesser-rated companies, I weigh the cost of the insurance put against the premium received from the LEAP put written and the perceived downside risk. If I feel there is little downside risk (because the market is particularly strong, or the stock is bottoming out after a pronounced retreat), I will not bother purchasing an insurance put. If the market seems weak and the stock is well above its lows, I am far more likely to consider the use of an insurance put—or not selling a LEAP put at all.

Having said this, I would recommend the use of insurance puts when doing your first few transactions. It will make you, your broker, and your broker's branch manager more comfortable as you learn the ropes and become more proficient in selling naked puts. As your asset base grows and your option experience builds up, you can begin relaxing this constraint by phasing out the use of insurance puts, first on A rated companies, then on A- rated companies, and finally on B+ rated companies.

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