Hedging Options

When hedging options, you can protect a long or a short position in the underlying commodity, or can serve to reduce risks in other option positions. Whenever options are bought or sold as part of a strategy to protect another open position, it’s described as hedging. If you’re in long hedges or hedging options long, you’re protecting against price increases. While in short hedges or hedging options short, you’re protecting against declining prices.

By using some of the various forms of combining spreads, straddles and strangles, as we just did in our previous examples, we were engaged in a form of hedging.
 

VARIABLE HEDGES

In a variable hedge, you’ll have an uneven number of option positions open. For instance, you might buy two calls and sell one call at a lower striking price. By doing this, you will:

          a) Get back some or all of the premium money you put out

          b) Have a chance of profiting from the short call

          c) Offset any potential loss from the short call with potential gains from the long calls.
 

Examples

Suppose the price of corn is currently $3.40 a bushel. You buy three September $3.50 corn calls at $200 each, for a total of $600. You also sell one September $3.40 corn call (at the money) and receive $750. Thus, your account is credited with net proceeds of $150 ($750 – $600 = $150.) If the price of corn rises above the striking price of $3.50, you’ll begin profiting from the three calls you bought at a ratio of 3:1. That is, you’ll make $3 from your long position for every $1 you lose from your short position. The more the price of corn increases, the more you’ll profit with this variable hedge position. However, you can still profit with your short position. Let’s examine some of the possibilities:

  1. The price of corn goes up to $3.50. This of course triggers the buyer of your $3.40 call option to sell back the option, making 10 cents on the option. On the other hand, the three call options you’ve purchased are still worthless since they’re just now at the money.
    Outcome = You incur maximum losses of $350 (.10x 5,000 bu = $500; $500 – $150 = $350.)

     
  2. The price of corn goes up to $3.53 1/2. You lose $675 from your short position (.1350 x 5,000 bu = $675). However, you gain $675 from your long position (.0350 x 5,000 bu = $175;  $175 x 3 options = $525;  $525 plus the $150 premium = $675.).
    Outcome = You break even.

     
  3. The price of corn goes up to $3.53 1/2. You lose $675 from your short position (.1350 x 5,000 bu = $675). However, you gain $675 from your long position (.0350 x 5,000 bu = $175;  $175 x 3 options = $525;  $525 plus the $150 premium = $675.)
    Outcome = You break even.

     
  4. The price of corn goes up to $3.70. You lose $1,500 from your short position (.30 x 5,000 bu = $1,500.) However, you make $3,150 from your long position (.20 x 5,000 bu = $1,000;  $1,000 x 3 options = $3,000;  $3,000 plus the $150 premium = $3,150).
    Outcome = You make $1,650 profits ($3,150 – $1,500 = $1,650.)

     
  5. The price of corn jumps to $4.00 a bushel. You lose $3,000 from your short position (.60 x 5,000 bu = $3,000.) However, you earn $7,650 from your long position (.50 x 5,000 bu = $2,500; $2,500 x 3 options = $7,500;  $7,500 plus $150 premium = $7,650).
    Outcome = You make $4,650 profits
    ($7,650 – $3,000 = $4,650.)


As you can see, as the price of the commodity rises you’ll make more and more money. Also, notice your narrow losing zone. In this case, anywhere from $3.41 to $3.50, where you can lose a maximum of $350.

 In other words, your total risk with this hedge strategy was $350. Your losing zone was narrowed to a 10 cents range. And your profit potential was unlimited.

Of course, you could have gone the other way and have taken on a much more aggressive hedging position, by assuming a short variable hedging position.

 

Example

With the price of corn currently at $3.40, you sell four September $3.50 corn calls for $500 each. You also buy two September $3.60 corn calls for $150 each. This leaves a $1,700 credit in your account ($2,000 – $300 = $1,700.) Obviously, your profit potential on the short side will be greater with a short variable hedge than with a long one. In this case, your total potential profit is $1,700. But if the price of the commodity increases, your losses will increase the higher the price rises. Here’s the scenario:

  1. The price of corn declines, remains the same, or increases up to $3.50.
    Outcome = You make a $1,700 profit.

     
  2. The price of corn goes up to $3.60. Therefore, your four call option buyers exercise their option and you lose $2,000 on the short side.
    Outcome = You lose $300 ($2,000 – $1,700 = $300.)

     
  3. The price of corn goes up to $3.70. Therefore, you lose $4,000 from your short position. However, you offset part of these losses with your two long positions (.10 x 5,000 bu = $500;  $500 x 2 options = $1,000;  $1,000 plus the $1,700 premium = $2,700.)
    Outcome = You lose $1,300 ($4,000 – $2,700 = $1,300.)

     
  4. The price of corn jumps to $4.00 a bushel. You’re losing 50 cents per option on your four short positions, and earning 40 cents per option on your two long positions.
    Outcome = You lose $4,300 ($10,000 – $5,700 = $4,300.)

Clearly, as the price of the commodity rises, your losses start adding up at the tune of a $4 loss for every $2 gain.

Go to Box Spread / Calendar Spread to continue.
Or back to Straddles for a review.