If you have any questions, feel free to email Ken Wolff or Shawn Wolff

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MTrader Class (C) copyright MTrader  2006

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Hedging with Options by Racerick...    

[09:35] <KenWolff>  TIME FOR CLASS...
[09:36] <KenWolff>  racer is going to give us another class on Options....
[09:36] <racerick> Y, Ken needs one more class before he can write book
[09:37] <KenWolff>  yeah...
[09:37] <racerick> Ok, today we're going to talk about using options to hedge
[09:37] <ceebee> sorry to miss it - will catch up later
[09:37] <racerick> One of the primary uses of options is to hedge.
[09:37] <TNtrdr> just depends whose version gets to the publisher first is all
[09:37] <racerick> This is done by many investors, institutions and of course, hedge funds.
[09:38] <racerick> Now remember, unless you've got a seat on one of the option exchanges, it's tough to play options in a day-trading environment, at least for scalps, mainly due to the spreads.
[09:38] <racerick> Can use if you're looking for a point or more move, but for our purposes, best if you think of more in an intermediate term.
[09:39] <racerick> This can be anything from a day to several months.
[09:39] <racerick> I'm going to give you some examples of basic trades that I use often, but I'm not going to get into elaborate spreads or arbitrage situations.
[09:39] <racerick> In its simplest form, mainly what I'm going to cover today, is how to utilize to take advantage of certain situations.
[09:39] <racerick> I'm going to give you a short term example and a long term example
[09:40] <racerick> Now why hedge?
[09:40] <racerick> PROTECTION , it's insurance and realistically, just smart money management.
[09:41] <racerick> Will definitely help you sleep better and gives you certain comfort level if you're playing a stock for a bigger move.
[09:41] <racerick> Now for Sobek, that will be a .20 move instead of .12 move, but some of us mere mortals, occasionally it's nice to make a 10 point move.
[09:41] <KenWolff>  yeah
[09:41] <racerick> Just kidding you sobes.
[09:42] <racerick> Example one: During middle of April AAPL had come down from mid 80's at first of year to the high fifties towards the end of March.
[09:42] <racerick> From there it had bounced to the low 70' an indicators were looking a little better
[09:42] <racerick> In a matter of about 2 weeks had bounced almost 14 points by April 8th from it's 200ma all the way back over it's 50ma.
[09:43] <racerick> So that showed there was some interest in the stock, plus we were getting into earnings season.
[09:43] <racerick> The stock kind of just drifted back down to low 60s and then turned back up.
[09:43] <racerick> I moved in around 64 as an earnings play, since I felt they would be better than a lot of people expected.
[09:44] <racerick> A lot of people expected they would really drop off because sales of Ipod would really decline  after xmas.
[09:44] <racerick> But sometimes it helps to have a teenage daughter and to coach a hundred other teenagers.
[09:44] <racerick> Anyway it moved up a couple of points over the next couple of days to earnings day.
[09:45] <racerick> They were going to release after mkt close and stock was bouncing all over the place that day.
[09:45] <racerick> So I had a dilemma.
[09:45] <racerick> Do I sell before the release and book a sure 2-point profit, or stick to my original premise that the earnings would be a lot better   than expected.
[09:45] <racerick> Based on the actions of the stock the prior 10 days I felt there was an additional 5-point gain to be had, but if I was wrong, stock would probably open at least 4-5 points
[09:46] <racerick> Lower
[09:46] <racerick> Since I had a pretty decent sized position I hedged
[09:46] <racerick> Fortunately, I love it when this happens, we had expiration week for the April options cycle that week, in fact only about 3 days later.
[09:46] <racerick> So what did that mean?
[09:47] <racerick> CHEAP premiums
[09:47] <KenWolff>  yeah...
[09:47] <racerick> Keep this in mind in October for earnings plays
[09:47] <racerick> The stock was bouncing between 65.50 and 67 that day, so I was able to purchase an April 65 put for about .75.
[09:48] <racerick> I was willing to risk .75 for the chance to make an extra $ 5, but not $5, if I was wrong.
[09:48] <racerick> Earnings and outlook came in good, stock opens at 69.50ish the next day.
[09:48] <racerick> I'm dancing a jig around my office
[09:48] <racerick> So I closed out the stock for an extra 4 points over previous days close and sell the puts for .25.
[09:49] <racerick> Net result was pretty good. Of course stock sells back down over net couple of days and I believe puts actually hit 1.25. But I was long gone by then.
[09:49] <racerick> Now obviously they don't all turn out this well, but you can see the principal behind the trade.
[09:49] <KenWolff>  yeah... very interesting..
[09:49] <racerick> Now the next trade is a much more common one.
[09:49] <KenWolff>  before you go on...
[09:50] <racerick> yes
[09:50] <KenWolff>  can you give the example on AAPL.... in shares... obviously you would not hedge if you had 100 shares.... so how many makes it worth doing
[09:50] <KenWolff>  5K is my guess..
[09:51] <KenWolff>  and if I had 5K... how many contracts would I buy....
[09:51] <racerick> Depnds on your risk tolerance and the individual. I agree, if only a few hundred or so, may not be wiorth doing.
[09:52] <racerick> Of course I'd hate to take a $1500 hit on 300 shares.
[09:52] <KenWolff>  true
[09:52] <sunlight> even for 500 shares in racers example, it costs 375 plus 10-20 bucks for the commission at a discount broker... to have a shot at $2k profits
[09:52] <sunlight> not a bad insurance premium imo
[09:53] <racerick> But, yes, it was a fair amount
[09:53] <KenWolff>  so if I had 5K shares long on AAPL... how many put contracts would you suggest I do ???
[09:53] <racerick> 50
[09:53] <KenWolff>  Ok... cool... thats what I was thinking... makin sure I am in the ball park with you... thanks
[09:54] <racerick> If px was right. could do any number. Not like you're writing, doesn't limit your upside [09:54] <racerick> BA is a stock I've been watching for awhile.
[09:54] <racerick> It's had an incredible run over the past four or five years.
[09:55] <racerick> Back in May, the stock topped around 90 and dropped to the mid 70s fairly quickly and then meandered around going back up to the mid 80's in mid June and then drifting lower again.
[09:55] <racerick> Now why is this significant?
[09:55] <racerick> Well, first of all BA had a ton of good press the past few months, especially with the Airbus meltdown. They're winning the airline order war.
[09:56] <racerick> Problem is, now they have all these orders, so now they've got to produce a radically new plane with a ton of new technology with partners scattered all over the world in a reasonable amount of time.
[09:56] <racerick> Easier said than done.
[09:56] <racerick> Forget the fundamentals though. Look at a chart - about a 4-year one.
[09:56] <racerick> Notice anything.
[09:57] <racerick> About 3 years ago the 50ma crossed over the 200ma and since then only about 4-5 times have the short MA s crossed below the 50 and then not for long and they've never once crossed under the 200 ma until just recently.
[09:57] <racerick> Notice the big curve down in the 50ma and in fact unless something drastic happens it will cross back under the 200 ma in the next week.
[09:57] <racerick> That will be significant to a lot of longer-term technicians
[09:58] <racerick> Anyway, about 6 weeks ago, I was able to get a short off at around 82.50ish.
[09:58] <racerick> Simultaneously I bought a relatively short-term 85 call as a hedge.
[09:58] <racerick> This cost about 2.50, so in effect lowering my short px to around 80
[09:58] <racerick> Now remember Ken always tells us to sell some of these thin trading momo stocks while they're still moving up and there are still buyers.
[09:59] <racerick> And I told you in an earlier option class that if you're selling options, you want to do so while people are optimistic about the stock, because perception has a big influence on premium.
[09:59] <racerick> Well when you're hedging, a lot of time this works in your favor, because you're usually buying the option in the opposite direction to which way the underlying stock is moving,
[09:59] <racerick> Often times,
[10:00] <racerick> Therefore, your insurance can be pretty cheap, especially if it's not on a particularly volatile stock.
[10:00] <racerick> The other thing that you can do is that once the stock moves sufficiently in your direction, you can often times sell the option for something.
[10:00] <_tradamom> hi, just wanted to let you know i entered class
[10:00] <racerick> That way, you get some of your insurance premium back
[10:01] <racerick> That's what I did with the BA once stock got down to about 78.
[10:01] <racerick> It's not a real volatile stock, and don't think it's going to get bought out anytime soon.
[10:01] <racerick> The further it gets away from your exercise px and closer to expiration, then obviously px of the option is going to drop quickly.'
[10:02] <racerick> So once it served its purpose, get rid of it.
[10:02] <brian1> ya ... a melting ice cube on a hot summer day [10:02] <racerick> Now say BA keeps moving down to 60-65, then may want to buy another call to hedge in case of a bounce, basically a short term box.
[10:02] <sunlight> still short BA racer??
[10:02] <racerick> yes
[10:02] <sunlight> nice
[10:02] <racerick> Now obviously if you're shorting a stock that could get bought out, probably behooves you to keep.
[10:03] <racerick> Good example would be some of the oil stocks. some of these smaller ones could get bot out
[10:03] <racerick> If you thought they may keep going down, you might be right or you may be chasing down here, so to buy some calls to hedge your short may be the prudent thing to do.
[10:04] <racerick> Gold has been dropping a lot lately.
[10:04] <racerick> If you thought it was going to keep going could short but use an option to hedge, or vice versa
[10:05] <racerick> Anyway, that's just a couple of examples of how you can use.
[10:06] <KenWolff>  interesting indeed
[10:06] <racerick> Any ?s
[10:07] <racerick> You need to always do with a stock that has potential to exceed your premium
[10:07] <KenWolff>  do you play many earnings stocks ??
[10:08] <KenWolff>  front run them.... then hedge??
[10:08] <racerick> Fair amount, and big dividend plays when they come around
[10:09] <phi1l>  we prefer to call that trading the positive sentimen, ken ..
[10:09] <KenWolff>  ahhhh..
[10:09] <racerick> A lot of the times will just use the options both ways
[10:09] <KenWolff>  sometimes if one stock beats big... you can play the sector...
[10:10] <KenWolff>  a strong sector move....
[10:10] <racerick> Y
[10:10] <KenWolff>  good information racer..... appreciate the class...
[10:10] <racerick> The only problem with using options in anticipation, a lot of times will be big premiums, so most of time stock relative cheaper unless you do real early
[10:11] <KenWolff>  yeah... gotta remember that time factor..
[10:11] <KenWolff>  its like stocks... its all relative... "time and value"