Do You Repair Or Do You Hedge Your Stock Position?

| June 12, 2012 | 0 Comments

I’ve recently mentioned 1,310 on the S&P 500 as a level to watch.

Now my focus is simply on 1,300 and if it can hold that level.

Again today is another gap up day with immediate weakness.

Yesterday, the S&P 500 stabilized for a bit in early trading with 1,317 as the trading area.   But today 1,304 seems to be that area.

Point is… I wouldn’t look to press any shorts unless we see a break below 1,300.

So, with all of this uncertainty in the market, huge daily swings, and an increasing volatility index, we need to ask ourselves a question.

How should we treat losing positions?

And one important thing you need to note is the difference between a hedge and a repair.

First, the hedge.  When you approach a stock for a hedge, you should be looking to put a floor under your stock.  A floor will generally mean straight puts or even a collar approach to completely define downside risk.

Now, let’s walk through some hedging facts…

One item some investors forget to account for is the cost of the put itself.

For instance, if you have a $27 stock and buy a July $27 put, you won’t lose any money no matter how far the stock falls other than the price of the put.

The only kicker is… if the stock stays flat.  Meaning that if the stock falls only by the price of the put premium or rises only by the amount of the put premium.

Basically, in a mental format, you have to accept the cost of the premium as a loss or a necessary insurance.

Think of it as term life insurance. You hope you never have to use it.  You look for the stock to go up forever and ever. But that’s not always the case, that’s why you own it!

This is only half the story…

On the flip side, when you look at repairs, you’re not as concerned about intermediate downside.

Generally, you’ll feel the upside is more capped along with the downside.

Repair trades are actually much more difficult than hedging trades.

You need to be prepared to see many repair trades through to the end.  And that can be tough for many traders.

If I’m trying to map my repair trades so that they lower my average cost-basis as the stock sits now and can still be profitable on little, if any, move on the stock.

I also measure what the difference will be by looking at the repair trade through to the end and having the stock called away from me vs. just holding the stock with no protection.

For example, let’s look at the rescue trade my colleague recommended on Qualcomm (QCOM) not too long ago.

The assumption was that you bought 100 shares of QCOM at $66.50 before earnings.

But after earnings, the stock fell sharply to $64.00 a share.

In that case, selling the QCOM October $67.50 covered call was a great rescue trade.

You would’ve sold the Oct $67.50 call for $2.90 and immediately collected $290 in option premium.  That would’ve automatically put you back in a profitable position.

Now, the two possible ways for this trade to get the stock back to breakeven or even profit.

First, if QCOM is above the $67.50 strike on October 20th (options expiration day).

In this case, the call option holder will exercise their option.  Your 100 shares of QCOM will be called away or sold at $67.50… a profit of $100 ($6,750 – $6,650) on the stock.  You’ll also collect $25 in dividends.  And you get to keep the option premium of $290.

You’re out of the trade with a $415 profit or about a 6% gain.  Not too shabby after being down more than 4%.

The other scenario is QCOM is below the $67.50 strike on October options expiration day.

In this case, your call option expires worthless.  You get to keep your 100 shares of QCOM, the $25 in dividends, and the $290 in option premium.

The result is you’ll now own 100 shares of QCOM at an average cost of $63.35 per share.

Bottom line…

It all comes down to tolerance.  There’s no right or wrong answer.

In the end, you need to establish your risk tolerance and stock thesis before deciding whether attempting to repair a position or simply hedge a position.

Safe Trading,

Marcus Haber

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Category: Options Trading Basics

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.