Hedging your Money with Calls

06/19/2017

What if your stock goes down?

What if your company has some bad news and the market reacts?

While investing in my ESPP has given me the 10% discount, the stock has never once dropped so far that it wiped out my headstart. My company’s stock dropped 5% on friday and I was sitting at a 12% gain before that, so I was left with a sad 7% gain to stare at all weekend. Since I haven’t seen the stock this low in many years, it would be an excellent time to put in an order, and I had ~56 hours to think about doing that.

I currently have an open sold call option on 100 of my ESPP shares, and when the 90 day holding period ends in July on another 100 shares I will sell another call on those too. When you sell a call, you take in a premium – cash that you get – that in exchange, commits you to sell the stock at the expiry date if the stock price is at or above the strike price. You can look at this extra money in a couple different ways: extra profit, or a hedge. These are of course the same thing, but it depends on your perspective and your strategy. One thing to consider is your choice of how much profit to shoot for; if you sell a 90 day call for $200 ($2.00/share) at a strike price of $90, or instead, sell a $100 ($1.00/share) call at a strike price of $95, you have decreased both your premium and your “risk” of selling, but if it does sell, you have gained an extra $400! (The difference between 100 shares of $90 and 100 shares of $95 minus the $100 difference between premiums).

We could all just buy our $25,000 of ESPP stock and sell it 1 year later and pay LTCG taxes, or we can sell calls on 100 shares at a time 3 to 4 times throughout the year (if options are available and if the stock price is within a reasonable window like $25-90). One of these choices is much more sexy and exciting of course, but it is also more profitable as I have shown in my previous post. Another point I did not exploit the explanation of is that the LTCG method would cost you an extra $16,000 of spent/invested money to save you $520 in taxes, which sounds a lot like a buy-more-save-more deal at the carnival to me!

Options as a Hedge

As I have mentioned, when the stock price took an unusual drop of 5% this past weekend, the value of my option premium went from $394 to $247, technically a $147 profit that I could take by buying back to exit the contract. I will stay in the contract for now, and if it goes down to ~$100 in the next month or so then I would probably buy that back to sign new contract. This brings me to the term Time Decay, or Theta. As the time of the contract nears expiration, the likelihood of the stock price moving x amount decreases (with more time comes more possibilities). If something is a sure thing, then there isn’t much money on the table, right? If I sell a call for $394, that’s a big number that shouts “anything can happen!”, but as the contract nears expiration, the value decreases because the shouts get quieter. And that is Theta.

Conclusion

I could look at my current $394 premium I took in on the 5 month call, (yes it was a very long expiry date but I liked the premium enough) as an extra ~5% profit that brings me from the 12% I was at to 17%, or if I keep the cash free in my account in case the value of the option goes down (the Market determines that the likelihood of the stock being at the same place upon contract expiration has decreased), then I could buy the call back at say, $247. If I get to hold $394, but I’m in a contract, I have an obligation to something or someone, but if I pay back $247, then I get to keep my $147 profit free and clear. My main point – My stock took a 5% dive, and my option gained 37%, which hedged my total position by 14.7%.

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–KEN

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