Hedging With Puts And Calls
In times of so much so of volatility and uncertainity in the market, some investors prefer turning their ways to hedging using puts and calls versus stock to reduce risk. Hedging can also be promoted by hedge funds, mutual funds, brokerage firms and some investment advisors.
Hedging with puts and calls can also be done versus employee stock options and restricted stock that may be granted as a substitute for cash compensation.
The case for hedging versus employee stock options tends to be stronger than the case for hedging versus stock.However, a higher degree of expertise is required to efficiently hedge the employee stock options, given the lack of standardized exercise prices and expiration dates, tax considerations and other issues.
Understand the Risks and Rewards Options, whether exchange traded calls and puts or employee stock options, are certainly more risky to own than stock. There is a greater chance of quickly losing your investment in options compared to stocks, and the risk increases as the option gets closer to expiration or moves further out of the money (OTM).
Next, given your better understanding now of the risks associated with holding the positions that you have, determine how much risk you want to reduce. You may perceive that you are too concentrated in one stock and wish to reduce that risk and avoid paying a capital gains tax or pay the costs of an early exercise of the employee stock options.
Make sure you understand whatever tax rules apply to hedging so that you are not surprised after the event. There are special tax rules that apply to hedging employee stock options, and these are different from those that apply to hedging stock.
When to Buy and Sell
One of the most important decisions to make is when you should sell calls and buy puts. Is the best time to be selling just prior to earnings announcements when the premiums are pumped up or is the week after the earnings are announced the best time to buy puts? And should you consider the implied volatilities of the options hoping to sell overpriced calls and buy underpriced puts? Often, recently pumped up volatilities imply that something may be in the works and some people are trading on inside information. Perhaps not hedging all the positions at one time is the more prudent approach.
Would you sell calls on the day the executives were granted large amounts of options or sell them two or three weeks later? Do you know how to identify what the executive insiders are doing with the securities of the prospective hedged security? There is evidence that when employee stock options and restricted stock are granted to executives, there is a much better chance the stock will increase rather than fall in the following month.
Hedging definitely has its merits, but it has to be well thought out and it is probably best to seek advice from someone experienced in this practice before trying it on your own.
For related reading on hedging, take a look at A Beginner’s Guide To Hedging and Practical And Affordable Hedging Strategies.