Over the next several weeks, most of the members of the S&P 500 will release earnings. Because of the volatility we have seen in the market and individual stocks, I want to highlight a hedging strategy that you may want to consider for your personal holdings.
I’ll use a hypothetical example to illustrate: I’ll hypothetically own 1,000 shares of Facebook (FB), which is currently trading at 73.50. Because I’m concerned about how the stock will to react to earnings, I’ll buy a Bear Risk Reversal.
To “hedge” my stock position, I could:
Buy to Open 10 November 70 Puts for $2.90, and
Sell to Open 10 November 80 Calls for $2.00.
This is a capital outlay of $900.
If Facebook shares are unchanged on November expiration, I would lose $900, essentially my insurance policy.
If Facebook shares go to 80 or above, I would make $6,500 on my stock position, minus the $900 insurance policy, or $5,600. However, my gains would be capped if the stock were to go above 80 as the buyer of the 80 Call that I sold would now be able to buy my stock from me.
To the downside, if FB were to go to 70 or below, I would lose $3,500 on my stock position plus the $900 insurance policy. However, my losses would be capped as I could exercise my right to sell my 1,000 shares of FB at 70—essentially removing the “disaster scenario.”
If you’re not concerned with the downside of a stock holding, or do not want to cap your upside, then this is likely not the strategy for you. However, if you are concerned, then this is a low-cost strategy.
If you have any questions on this strategy, please don’t hesitate to email me. As always, I want you to be completely confident in what you’re doing and understand the various scenarios.
Please note that to initiate such a strategy you should buy and sell one option for every 100 shares of stock you own. Also, this strategy can work at other times, not just at earnings.
And the strategy can be used in any number of strikes. For example, you could Buy the 65 Put and Sell the 85 Call.