Hedge even cheaper -- if your contract permits it.
Disclaimer: This article is intended to only to assist you in understanding possibilities. I am neither a lawyer nor investment adviser. None of this information is intended to serve as legal, tax or financial advice. I do not put any guarantees on this information and am not liable for any action you take or fail to take based on information that exists on this site.
Consult with an attorney, CPA, and/or investment adviser before pursuing any action.
As discussed in the prior post, buying a put can be expensive. e.g. a put with a strike 10% below current price might cost 10% of your current asset value.
If your market standoff agreement permits you to write options (remember to validate with your company's equity operations and/or a lawyer), you can pay for the put option with your “upside” rather than money.
A call option gives the holder the right, but not obligation, to buy a stock at a given price, before some
For the purposes of hedging, you’ll be writing (selling) the call. When you hold the underlying shares, this is known as having a “covered call”.
Fun fact: Employee stock options are call options with a very far out expiration date.
By using the proceeds of the call option to purchase a put option, you can hedge for no cost!
In effect, you’ve sold your upside to protect your downside. Your stock probability distribution (described earlier) now looks like this:
First Understand the basic steps.
As discussed earlier, to be conservative with your agreement, don’t constructively sell. You have constructively sold your asset if you effectively have ceased taking risk on the stock your options "straddle". Example:
No matter what, you walk away with $100. You’ve “sold” (constructively).
Many accounting practitioners believe the collar band (call strike less put strike) must be at least 15% of the underlying value to not be a constructive sale. This means that in practice, you’ll need to accept a 7% downside risk or so on a zero-cost collar.
Again, if you have over $5M of stock, stop here and contact an investment bank. They may be willing to sell you a collar directly. If you have under $5M, they likely won’t be interested enough to bother.
In the ideal world, you will have the shares in the same account you are writing the calls. If this is true, there is no margin hit — the broker understands that the calls are backed by your stock.
However, during lockup, you are very unlikely to be able to trade in the account that holds your stock. From the brokers point of view, your calls are not backed by stock — they are naked calls. Consequently, you'll be using margin.
Do not write naked calls! If the stock goes up, the broker owning your options will think you are losing — and you might getmargin called. This might force you to sell your calls at a loss and if the stock dives back down - you end up in a much worse place than when you started: “whipsawed”.
To avoid writing naked calls (with unlimited downside), you are going to buy a call option (a “long call”) that is at a even higher strike price. You thus will have a protective put plus a bear call spread.
For instance, if you wrote a call at a $111 strike and buy a call at a $141 strike:
You have a few parameters to play with:
Long call price You’ll generally want the maximum distance between the long call and the written call (since you aren’t concerned with capturing the extreme upside). This is limited by your capital; borrowing money becomes much more important than with puts alone. Determine the available margin basis points you can safely consume (less the ones going to puts!) and divide by the number of shares you wish to protect. That will give you the distance between the two strikes.
Zero-cost or pay? Because you need to pay for the long call, you’ll have less premium to buy the put option. You can either:
When trading, many brokers offer the ability to buy multiple options as a single "all or nothing" transaction
If the stock goes up and your out-of-money call options goes into the money, it is possible that the holder will early-exercise it (This is called being assigned), which will leave you with a short position on the stock. In practice with a non-dividend paying stock, this is pretty unlikely to happen unless the call goes so deep into the money and is so close to expiry that the difference between the asset price (spot) and strike price is close to the premium.
This is just a more complex straddle than the protected puts described earlier.
Excess investment interest needed to “hold” your asset positions (had you liquidated them, you’d have more margin BP) can be deducted on schedule A.