FFO Options 15: Hedging Your Best Bets With Options

1. FFO Options 15: Hedging Your Best Bets With Options Dr. Scott Brown Stock Options

2. Introduction • Option trading goes far beyond the purchase of calls and puts. • You can mix and match calls and puts, longs and shorts, different expirations, or even different quantities to create truly unique strategies and opportunities. • The true power of options is realized once you understand how to hedge with options to shift your profit and loss curves in different directions as the underlying stock is moving.

3. Hedging • Origin of Hedge – borrowed from early farmers who used to plant shrubs along the perimeter of their farm to create a protective barrier. • In finance, a hedge is an investment that is taken out specifically to reduce or cancel the risk of another investment.

4. Example • Suppose you are taking a 10 question exam in which you must match 10 terms in the left column to the 10 definitions on the right column. To pass the class, you must get a score of 90% or higher. • You know you answered the first 8 questions perfectly and currently have secured a score of 80%. • Now, you have two questions you must match with the remaining two definitions but are not sure which is the correct answer.

5. Example (Cont.) • You have two questions: • Try to get guess with a 50% chance both will be right (resulting in an 100% return if correct) and also a 50% chance of getting both wrong in direction (resulting in an 80% failing core). • Use the same definition for both terms and having a 100% chance of getting 90% score and passing the class. • The goal of the student is to pass the class, not get a perfect score. Which is the right decision? • This would be a prime example of hedging, betting against yourself (not getting 100%) to guarantee a success (guarantee 90%).

6. Betting Against Yourself • Hedging means we give up some upside potential in exchange for less damage to the downside. • A hedged portfolio means we bet against ourselves much like the exam. • If we are bullish on the market, we may add a few bearish investments to hedge our bets. • Hedging is the key to making consistent money in the markets.

7. What kind of Risk Takers are we? • Every day we’re faced with making decisions about risk. • Subconscious calculations are always taking place regarding which risks to take and which to avoid. • Psychologists have created 3 general categories for risk: • Risk Adverse – those who avoid risk. • Risk Neutral – those who accept reasonable risk. • Risk Seeking – those who accept high risk situations. • When it comes to money, people become very predictable and display a consistent view of risk.

8. We really despise Risk • The American Psychologists - Daniel Khaneman & Amos Tversky: • Research that showed the risk-averse nature of humans. • In the study, the researchers gave subjects a choice between the following two alternatives: • $500 gain for sure • Flip a coin and get $1,000 if heads and nothing if tails. • Most people picked choice A – the risk adverse choice.

9. We really despise Risk (Cont.) • However, the researchers added an interesting twist and asked the following intriguing questions: • Take a $500 loss for sure. • Flip a coin and lose $1,000 if heads and nothing if tails. • The two researchers expected risk avoidance in the first set of questions, avoiding risk and accepting a $500 loss for sure. • Oddly enough, most subjects selected the second alternative. • This means that investors’ aversion to loss overcomes their aversion to risk.

10. We really despise Risk (Cont.) • If a trade is moving against us, it’s our nature to try to gamble our way out. • When we have winning trades, it goes against our nature to hang on – we’re too afraid of losing these gains we already have. • Hedging your position prevents both of these behaviors and allows you to capture bigger profits. • Hedging is a powerful tool and the key to financial success. Professional investors know how to effectively hedge. • Options were designed to hedge.

11. Stock Swap • Most simple and useful hedging technique, but also the least used. • Involves selling all your shares and buying an equivalent share amount of call options. • This is useful when you feel the stock is reaching the top of its upward trend and want to secure your profits but still want to stay in the position. • You would be giving up the upside but would be limiting your downside potential .

12. Stock Swap (Cont.) • It’s not the fear of lost opportunity that drives us to get out early; it’s the fear of loss. • The stock swap hedge removes all that fear. • If the stock price were to keep rising, we could perform a roll up to further guarantee profits. • Once again, it is a small sacrifice of upside potential in exchange for a much higher guaranteed return.

13. Laddering Hedging Strategy • Laddering – changes the risk at each run or step of the roll-up process. • Hedging is so versatile that we can even create hedges where we get our money back and actually increase the amount of reward. • Laddering stock swaps – say you want to perform a stock swap of 300 stocks you own. Instead of selling the 300 stocks and buying 3 call contracts (300 stock control), you can sell 3 call contracts them and buy 4 call contracts. • Laddering Roll Up/Down – increase the number of calls/puts bought after each roll up/down.

14. Selling Spreads Against Stock • Example: • You bought 500 shares at $53 now worth $56.50. You feel the stock will trend sideways for some time and may even fall. • You are afraid of a loss but don’t want to pay for the put. • A strategy you can perform to profit from sideways stock movements protecting from downside risk is selling a spread against stock. • Action: • Buy 5 $50 puts @ $0.55 = -$275 • Sell 10 $55 calls @ $3.20 = +$3,200 • Buy 10 $60 calls at $0.85 = -$850 • Net credit = +$2,075 & you profit from sideways stock changes & upward trends.

15. Conclusion • In order to succeed in the financial markets, you must invest relatively large dollar amounts and let the profits run. • By trying to avoid risk, most investors and traders actually place their money in maximum jeopardy. • In order to reach for bigger profits, you must remove the fear of loss. You must hedge your bets and bet against yourself. • Once you’ve locked yourself into a guaranteed winning position, hang on since trends last longer than most people expect.

16. Disclaimer • DISCLAIMER: THE DATA CONTAINED HEREIN IS BELIEVED TO BE RELIABLE BUT CANNOT BE GUARANTEED AS TO RELIABILITY, ACCURACY, OR COMPLETENESS; AND, AS SUCH ARE SUBJECT TO CHANGE WITHOUT NOTICE. WE WILL NOT BE RESPONSIBLE FOR ANYTHING, WHICH MAY RESULT FROM RELIANCE ON THIS DATA OR THE OPINIONS EXPRESSED HERE IN. DISCLOSURE OF RISK: THE RISK OF LOSS IN TRADING FUTURES, FOREX AND OPTIONS CAN BE SUBSTANTIAL; THEREFORE, ONLY GENUINE RISK FUNDS SHOULD BE USED. FUTURES, FOREX AND OPTIONS MAY NOT BE SUITABLE INVESTMENTS FOR ALL INDIVIDUALS, AND INDIVIDUALS SHOULD CAREFULLY CONSIDER THEIR FINANCIAL CONDITION IN DECIDING WHETHER TO TRADE. OPTION TRADERS SHOULD BE AWARE THAT THE EXERCISE OF A LONG OPTION WOULD RESULT IN A FUTURES OR FOREX POSITION.HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL, OR IS LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. PS.  In our opinion, we believe, it may be possible, that heavy smoking and drinking may be hazardous to your health.  If you choose to smoke and drink while trading, The Delano Max Wealth Institute nor Dr. Scott Brown is liable for any damage it may cause.  If you slip and fall on the ice, we're not liable for that either.