Part 1: Hedging Stock Exposure
For those of us who are involved in the buying and selling of assets, the feeling of buyers/sellers remorse is one that can remain with us for a while. As anyone who has participated in these markets can attest, it is almost impossible to sell at the very top and buy at the exact bottom. The feeling of remorse is not only frustrating, but it can lead to emotional swings that may cause a trader to veer off plan and make mistakes. Thankfully, there are things hedgers and speculators alike can do to help eliminate that remorse.
We’ve discussed the ratio spread in a previous article. For those who are new to this strategy, it involves the simultaneous purchase of one option along with the sale of two options. This spread can be done many ways, but for the examples explained in this article, we will be buying one call close to the money while selling two calls further out of the money. Let’s jump into a real time example. For this blog, we will examine this strategy and discuss how a stock investor can use a re-ownership ratio spread strategy to “have his cake and eat it too”.
Jim is a buy and hold stock investor. He has a stock portfolio of approximately $130,000 that is highly correlated with the S&P 500. Jim realized over his life that timing the purchases and sales of the stocks in his portfolio has been difficult. Jim suffered through the stock market drawdown in 2008, and he hasn’t sold anything during the last 3 years. He has been faithful to this buy and hold formula. However, as his retirement age approaches, he realizes that he might need to scale back the holdings in his portfolio as the markets have been friendly to him lately. Because of these feelings and his ability to do basic chart analysis, he feels that the S&P will be getting “toppy” around the 1340 levels. He wishes to cut his stock investments by approximately 50% around these levels. (50% of his stock account is $65,000, which is very close to the value of 1 E-mini S&P futures contract, 1310 x $50 per point= $65,500).
Because of his lack of fortune when it comes to timing, Jim dedicated himself to learn about re-ownership strategies. He had never traded futures or options before but knew of the leverage the futures markets provided to make this strategy work. He understands that this strategy is a dual market strategy. He will be making “cash” sales in his stock account while entering a ratio spread in his futures account. Jim provided his Daniels broker with his understanding of the strategy and his demands for upfront cost – his broker took care of the rest.
The trade will be executed like this:
Jim will sell 50% of his stock portfolio when the S&P 500 hits 1310. Simultaneously, he will buy a 1310 June E-mini S&P 500 call for 60 points($3000) and will sell 2 June E-mini S&P 500 1380 calls for 30 points each ($3000). Because he is long the 1310 call, upon expiration in four months, Jim will make $50 dollars for every point the S&P 500 is over 1310. He will cease making money if the market would expire anywhere over 1380.
If this were a normal ratio spread without any cash stock behind the trade, Jim would begin to take losses as the S&P continued higher over 1380. In this case, his futures account will take losses for every point the E-mini expires over 1380, but those losses will be offset because he owns the equal (or greater) amount of stock. If the market rallies to 1450, he will not profit as the market runs higher from 1380-1450. If the market would sell off and expire in 4 months anywhere under 1310, his ratio spread will expire worthless with a net loss of zero before fees because he bought the 1310 call and sold the two 1380 calls for equal amounts. If the stock market would take a turn for the worse and sell off a substantial amount, Jim would not be taking the losses he would have before because he has already sold a portion of his stocks.
We call this a re-ownership strategy because Jim sold stocks in his cash account and “re-owned” the stock index on the board using options. When doing a strategy such as this, it is very important to understand what will happen to both accounts wherever the S&P 500 would be in June of 2012.
For more questions on this type of strategy and how you can use it to help protect your investments, contact a Daniels Trading broker at 800.800.3840
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