In the last blog we had shown you the Perspectives of Hedging in Stock Market. In this article we are concentrating on the break even point calculation, possibilities and probabilities of break even point calculation in stock market.
It is important, also, to always know exactly where your break even point calculation is so that you understand your possibilities and probabilities of turning a profit. On spreads . and straddles, you must be sure you understand what it will take for you to move out of the red and into the black, and that immediately upon setting up a spread or straddle you are in the red. Brokerage commissions make sure of that.
If you buy 1,000 shares of Citicorp for $30,000 and pay a $300 commission, the stock only needs to move about 5/8 of a point before you begin to profit (given another $300 in commissions on the sale side). But if you hedge your position by buying 10 out-of-the-money puts for $1,000 including commissions; then your stock must move a full l 5/8 of a point before you break even.
For the Big Money, this is not a bad hedge, nor a particularly worrisome breakeven point. However, for the Little Money that can only purchase a few round lots of the stock at a time, the cost of hedging can push the break-even point relatively high.
Consider, for example, an investor who buys 200 shares of Citicorp at $30 per share and pays $90 in commissions. Including the sell commissions to come, mis means that the stock must move up roughly $1 per share before she can begin to profit. If she purchases two puts for $250 plus commissions, this means the stock must climb a full $2.25 per share before she will be in the black.
As you can see, the investment game favors the rich. The large amounts of money they can invest keeps their break-even points relatively low. The Smart Money above needed a mere l 5/8 of a move in the stock to profit; the Little Money needed 21/4. The Really Big Money can profit on moves of even l/4 of a point or less.
Investment firms with millions of dollars to invest in any single security have inherent leverage. The big bucks they come in with allow them to keep their breakeven points close to the entry point, as well as giving them great advantage in negotiating trading commissions when necessary. But they have a big disadvantage that the Little Money does not have it's very hard for the Big Money to get in and out of stocks very quickly.
Even with their great financial strength and teams of investment researchers, the Big Money is still very leery about leaving their positions uncovered. They may not always hedge with the tools described, for at their level of sophistication they can make more subtle types of hedges work very well for them. For instance, they may constantly change their cash to investment rations as the market rises and falls, or put equal amounts of money in varying stock groups. These are indeed effective ways in which to hedge one’s bet. Thus break even point calculation involves a high demand in the stock market hedging.
Hedging is expensive because it requires positions in two or more securities. It is not always ideal for the heavily bullish investor who wants to make a killing in the market. But few independent investors ever make a killing in the market, so playing it safe is always the best way to go by hedging investopedia.
Speculators should Hedge
It seems a contradiction to consider that speculators should hedge, for hedging by its very nature takes the speculation out of investing. Yet mere are speculative investments, such as options, which remain speculative even when spreads or straddles are being employed. There are many types of hedging investopedia, some designed for futures trading, others for options, some for bears, some for bulls, and so on. Those discussed in this chapter are, however, among the most practical for the small, independent investor.
Views of Investors
The Smart Money often hedges. Being naked (meaning unhedged or uncovered) in the market often tries one's mettle and often results in quick turnarounds or closing positions (in the case of options). Investors usually sleep better when they are at least partially hedged, as there is no telling when the market will suddenly jump to new highs or plummet to new lows. The same goes for stocks. The market always takes a dip once in awhile, just as it sometimes does a bull run. Isn't it nice to know that those 1,000 shares of IBM you own are insured by 10 puts that can quadruple in price if the stock falls 5 or 10 points? Isn't it also nice to know that short position in 1,000 shares of Merck is partially covered by 10 calls that will absorb some of your losses if the stock does a quick turnaround?
A good rule of thumb for the bull is to proceed on the basis that:
1. When the market falls, it usually falls at a higher percentage than it realizes when it's on the climb.
2. When the market falls, it falls with a vengeance. And it will dip and plunge at unexpected times.
3. Be prepared.
Many bulls were caught dusting their horns on Black Monday. This was the October 19,1987, stock market collapse. It started on the New York Stock Exchange and dominoed through the other American and world financial markets. The Dow Jones Industrial Average fell more than 500 points, over 20 percent of its value. Though trading remained heavy, there was little that could be done to stop the decline.
Prior to this event, the last major upheaval in market prices was the great Crash of 1929. But that was nowhere as drastic as the 1987 crash. The Crash of 1929 represented only about 13 percent of the DJ Industrials.
Don't run naked into the marketplace
The investment community still hasn't decided who or what was the culprit in the 1987 Crash. Many argue mat portfolio insurance and index arbitrage may have started the slide. Others argue that the fault lay with the inherent volatility of all world markets at the time. There was too much leveraging all around; the world markets were not firmly based.
In any event, bulls running naked in the marketplace got caught with their pants down. Merck dropped 22 points, IBM 13 points all in one single day. Investors owning those stocks who were also covering themselves with puts made out fairly well. Those with covered calls as hedges at least were able to offset some of their losses.
It can happen anytime. And to prove the point, look at October 13,1989. Tremors again! The Dow Jones Industrials dropped 190 points that day, sending a cold wind throughout the world markets. After 1987, they said it couldn't happen again. But it did; and it will happen again.
The lesson: Don't run naked into the marketplace. The hedging investopedia is can be utilized for better hedging in stock market.
Shorting against the box is another type of hedge, but one which is used for very different reasons. It is basically the shorting of an equal amount of the same stock in which you are currently maintaining a long position. It is generally used as a delaying tactic either for tax or delivery purposes. It puts your positions on hold. For example, if the long position goes up 10 points, the short position goes down 10 points.
Shorting against the Box
Karen Rigg owns 1,000 shares of Citicorp common, which she purchased at $15 per share. The stock is now at $40 per share, and her taxable gain if she were to sell the shares is $25,000. However, it is to her advantage to take these profits next year when she expects to be in a lower tax bracket. But if she tries to hold onto the shares until next year, they may go down in price. Thus, by trying to save tax dollars, she may lose three times as much through price depreciation. She, therefore, informs her broker to sell 1,000 shares "short against the box," and holds onto her short and long positions until after the first of the year. If the stock goes down in price, she gains on the short position while losing on the long. If the stock goes up in price, she gains on the long position while losing on the short. In other words, any price movement in the stock cannot affect her. She locks in her $25 per share profit less the additional commissions the short position will necessitate. However, she also prevents herself from being able to participate in any bullish surge by the stock. But that's the trade-off necessary in shorting against the box.
Reasons for shorting against the box
There are other reasons for shorting against the box. Sometimes an investor is not in a position to deliver securities in time to her broker, and she opts for also shorting an equal number of shares in the stock in which she is long. In doing so, she locks in her profits until she returns from her European vacation and can access her safe deposit box for the shares to be delivered.
An equally good reason to sell short against the box is the one that follows.
Suppose that someone gives you shares of stock as a gift. These shares have been in their portfolio for years. And suppose that these shares are at a price four times or more above their original purchase price. If you sell the stock, the cost basis for tax purposes is the original purchase price. Thus, you decide to hang on to the stock, for the capital gains are far too much at this time meaning, for someone in your tax bracket.
Good idea! But now assume that the stock is Merck or some other pharmaceutical under tremendous downside pressure because of the Clinton Administration's policies. This puts you between the devil and the deep blue sea. If you sell the stock, the tax impact is enormous. If you keep the stock, you will lose drastically when it plummets. Either way, it seems, you will lose either to the IRS or to the market place.
What to do? You guessed it Sell short against the box until it is advantageous to take your profits or maintain only a long position in the stock.
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Do you have to give up your stock if the related calls go in the money? No, absolutely not. If the underlying security reaches the striking price or passes it, you may buy back your covered call and then if you wish to reduce the loss on the option, may sell another one that is out-of-the-money. The premium from the second call will offset some or all of the loss from buying back the first, while you continue to profit from the surge of the underlying stock. You may continue to buy back and write new covered calls as long as it appears to be to your advantage.
The Safest Bet
The rule remains, however, that the safest bet is in writing out-of-the-money calls. The underlying stock is less likely to be called out from under you; the value of the call will depreciate quickly as the expiration date nears (which, as a writer, you want to happen; that is, time decay is on your side); and you will almost always sell the underlying stock at a higher price if it is called.
There are advantages, also, to writing at-the-monies and in-the-monies, but the disadvantages outweigh the advantages. For instance, with in-the-monies, the stock may be called at any time, and the chances of participating in a bull market for the underlying stock are rare; and with at-the-monies, a small upward movement in the price of the underlying stock puts your position in jeopardy. Premiums are also higher for at-the-monies and in-the-monies, which means higher commissions.
Serious Mistakes in Trading
There is a serious mistake that even the pros managing trust accounts often make. This involves the selection of the underlying security for any covered call trades. Brokers like to set up discretionary covered call programs for their customers. On the surface, these are great income producers for the portfolio as well as for the broker. The broker stands to earn much more in commissions from a covered call account because he can legitimately buy and write options on the same underlying stock many times throughout the year.
Which stocks to be Selected
Less sophisticated portfolio managers will often select underlying stocks that have calls commanding typically high premiums. These are generally higher-priced stocks which the marketplace feels have great upside potential. The broker gets to write calls and to buy them back as the underlying stock approaches the striking price. Or he just lets the stock be called. His argument is that the portfolio gains in the long run because of the high income received from the call writing. But the truth is, the portfolio often does better when the call writing program is balanced so that the portfolio can not only be buffeted by call premiums but also by the underlying stock's participation in any bull market.
Covered call writing is a balancing act. The portfolio manager must always be calculating the comparative advantages of a straight call writing program against one that also squeezes additional profits from capital gains in the underlying stock. Clearly take this share trading tips for beginners for making earnings in stock market.
The bull put spread example is explained in this article. Spreads are designed to take advantage of the price relationship between two or more options. Bullish speculators use primarily what are called "bull spreads" to reduce their risk. In the bull put spread example, the speculator buys and sells calls having the same (but not always) expiration date. The striking price on the calls, however, will be different. In a bull spread, the call written will always have a higher striking price than the call purchased.
Another type of bull put spread example is that may be attractive to the bullish investor is the calendar spread, wherein the speculator buys and sells calls with different expiration The bull spread is a strategy designed for those who have a very positive outlook for the underlying stock but. want to hedge just in case. They buy and sell calls at the same time. The call bought will have a lower striking price than the call sold but have the same maturity. The easiest way to do a bull spread is to purchase an at-the-money call and sell an out-of-the-money call on the same stock. The objective is to be long on the option that will have a greater price increase if the market rises. The short position, which produces income, reduces the cost of the long position.
Dates, hoping that when she makes her closing transactions the credits to her account will exceed whatever the costs of the spread were. The buy and sell transactions required to close out the calendar spread must be made simultaneously.
There are other types of bull put spread example, but these are either combinations of bull and bear strategies or require so many positions at one time that they represent too much of a hedge to make being in the market worthwhile except when some very special price movements occur.
Spreads of the above type, which are especially designed to hedge the speculator's bet, are very different from the types of spreads that speculators, such as arbitragers, may use as part of their aggressive speculative programs. In arbitrage, profits are realized from the spread between stock prices in different markets.
Arbitrage, however, is no game for the little guy. It is a game for only the highly skilled, the highly experienced, and the well-placed. By well-placed I mean that the investor is able to take advantage of immediate developments, which the average investor, listening to cable reports or occasionally checking his computer's stock quote program, cannot do.
Covered calls are by nature a hedging tool. With the covered call, you are immediately long on the underlying stock and short on the option.
With a covered call strategy, you can bring in extra income even when the underlying stock is relatively stagnant. This is because once you sell the call, you receive the premium (less commissions). The premium is yours to keep. If the underlying stock never reaches the striking price before expiration time, you get to keep the stock as well as the premium.
On the other hand, if the stock is called, you get to:
• Keep the premium.
• Profit on the underlying stock.
But you can only be sure of profit on the underlying stock if you have written covered calls that are sufficiently out-of-the-money.