Hedge upside risk with calls

January 15, 2015 05:43 AM

Question:

How can you take profit on a winning trade yet maintain upside potential?

Answer:

Hedge upside risk with calls.

Everybody knows that puts offer excellent protection against a downside move. Well, calls offer the same excellent protection against a move to the upside. And, no, I’m not talking about using calls to hedge against a short stock or futures  position. We’ll leave that to the hedge funds and market makers.  I’m talking about using calls to get out of a long position and still stay in the game.

Let me explain: We’ll take two scenarios. 1) You bought the stock or future at a lower price and you want to take some profit but are worried about missing a further move upwards, and 2) You bought the underlying asset at a higher price and want to cut your losses but are afraid of getting out at the bottom.

We will provide two examples: One using the stock market as a whole and one using a particular stock.  Two caveats before I begin. First, I am assuming a  frictionless market. By that I mean that I take no account of commission rates, the bid/offer spread, or any tax consequences. Second, the following examples are price specific as of Dec. 9 at 1:00 CST, and obviously cannot be replicated exactly. The purpose of this article is to demonstrate another way of looking at and using calls.

Let’s say that you have owned for some time a broad range of stocks roughly mimicking the S&P 500. We’ll use the ETF that matches the S&P 500, ticker symbol SPY (see chart right). 

As of this writing SPY is trading at 205.94, not all that far from its 52-week high of 208.47. And you want to lock in some profit before year end while at the same time keeping upward potential.

So, you sell your stocks and at the same time you buy the SPY January 2015 call with a strike price of 210. That option is offered at 1.10, or $110 per option.

If the market powers north above 210, your call kicks in and you only miss roughly four points, or just less than 2% of further upside. And, of course, if you have sold a top and the market turns lower, not only are you a perspicacious trader, that 1.10 was a small price to pay.

Now, let’s take another example, perhaps a less cheerful one. You believed the hype and bought Tesla Motors (TSLA) at a higher level than its current $215.50 (see chart right).

 You want to “bite the bullet” and take the pain before it gets worse. But, you are seriously afraid that you will sell the bottom. All experienced traders know that there are few worse feelings than taking a loss on a long position only to see it roar higher right after you get out.

All right, then. You sell your Tesla at $215.50 and at the same time you buy the January 2015 call with a strike price of 220 at its offered price of 3.50 ($350 per option).

If Tesla keeps moving higher, then you only miss another 2% before your call kicks in and you are back in the game. If Tesla keeps heading lower that 3.50 was still money well spent.

In fairness, I must say that your real risk here is that Tesla goes to 220 on the January expiration and then just “dies at the strike,” as we used to say on the floor. In that case, you not only miss the last 4.50 points, but your long call still expires worthless. Admittedly, though, that is an unlikely scenario.

This helps demonstrate the wonderful flexibility of options. Just as puts protect you from a move lower, calls protect you against a move higher.

Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Since 2006, Liss has educated and mentored traders.

About the Author

Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Liss has educated and mentored traders since 2006.