Options hedging strategies (FINRA SIE, Series 7, 65, 66)

We teach you how to use hedging strategies in your options trading to limit your risk. This is both useful for retail traders and a key options topic tested on FINRA and NASAA exams.

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Full Options hedging strategies video transcript:

0.1s
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35.1s
Let's look at a set of questions that relate to a hedging strategy together to see if he can better understand what's going on.

43.7s
All right, so an investor goes long. 100 shares of b c d stock at 53 and purchases 1 b, c d July, 50, put at 3 obviously you can see a number of questions we have up here. Everything from what's the strategy? What's Market sentiment? Max game lost break. Even get a loss is a different points so here's what you should do. Take a moment, pause the video and see how many of these questions you can answer on your own and when you're ready on pause and we'll talk about it together.

78.6s
Okay. Okay. Hopefully that was enough time for you to pause and unpause. Let's, let's go ahead and talk about this. All right, we have a long stalk paired together with a long option. The stock was purchased 53 and then the investor bought a July 50, put at 3 and that put is our hatch. In fact, that we tell them, we have a hedging strategy, you can usually tell you, haven't had your strategy when you have a stock position paired together with a long option. And in fact, that's what we have here. This is a particular and I'm sure you can see that t chart on our screen book for talk about that here in just a second. This is a long stock with a long put hedging strategy, there's no concise, ER, easy name, it's just a hedging strategy that involves a long stalk with long, but in particular, the long put is there to protect the risk of the long stock position.

135.2s
And what I'd encourage you to think about, okay? What is the risk with the long stock position? If you buy stock in 53, worst case scenario, the marketplace can fall all the way to zero that's $53 per share of loss that we're facing Todd's undershirts. That's $5,200 of them of a maximum wasp. Just in that position alone. The long put gives me a bastard, the right to sell stock at the strike price, which in our case, here is 50. So worst case scenario, the market price Falls, we can exercise the the point we can sell stock of 50

172.1s
Corset that put is not free. We to pay $300 for that insurance and we'll talk a little bit. I had that factors into, did the number sit here in just a second in terms of Market sentiment, whenever an investor engages in a hedging strategy, you can always tell what the market sentiment. Another way of saying are we bulshit we bear sure. We neutral. The market sentiment is defined by the market segment of the stock position. If I buy stock, I want the marketplace to rise. If the market price, here goes to 78, E150 300-1000 the higher, the marketplace goes, the better gift for the Ambassador.

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Now, if you think about the put, the put gives us the right to sell 50. Do you do you or does any of Esther want to buy stock in 53 and then sell it 50? No.

222.7s
The right to sell it. 50 is only going to be exercised if the market price were to fall below 50, which would not be a good situation for the for the Ambassador here. So, overall, what's the market sentiment that the investor is bullish? They want the market price rise, but they happen to spend a little bit of money on an option and now they have some downside protection and that downside protection will come into play when the market price Falls below 50, we have maximum gain maximum loss break, even and we have gained or lost as a different prices at the bottom. All these are little bit more math focused and for what you can see on your screen, you can see what we call a t-chart. Now, there's not just one way to do a t-shirt, but this is how I do a t-chart and this is how I consistently keep my number straight to do, you have to do a t-chart to to pass your exams, know how it out. But for those of us who are visual in like keeping the number straight, a teacher could be a significant use for your exam.

281.4s
And this is what my teacher looks like. I have a Plus on that on the top left of column, A minus in the top-right, condom, call him that can represent money in Money out. Plus his money into our pocket money. Has his money out of her pocket and then we have an option and a stock bro. Got a couple different ways. You can fill out a t-chart, you can plug in what I call. Small numbers are big numbers when I say small numbers of big numbers. The question is, are we going to be multiplying x 100 or we need to keep the number small and relatively manageable and just keep them on a dollar per share price. If that's what I do, I do this, the small numbers. So for example with this question here, the investor bought Hunter shows a b c d stock in 53 to put 53 on the minus side in the stock route,

335.0s
53. They're great. They also bought a 50 put it 3. The 50 is a strike price which may or may not come to play in order for 52 to be part of the teacher at the option, has to be exercise switch. Hopefully, you know, by now an option may not be exercised, they can expire betrayed it, but the one thing we can factor into the T. Chart is the $3 premium? Yes. Is it a $300 overall premium? Yes, but I'm going to put 3 on the minus side, in the option row. So we have a three on the minus side and we have a 53, on the stock side, which adds up to a total of 56. Be better spent the equivalent of $56 per share. Just by kicking off this option strategy here and $5,600 out of their pocket. Again whether you have 53 and 3 or 50 300 and 300 it really doesn't matter. Whichever way works to start talk about how to use this T chart released.

395.0s
System that I used two approaches the first system when the teacher for the potentials. And when I say potential, I mean maximum potential gain maximum potential lost. What I would recommend you do is instead of thinking about both of these pieces of the strategy mean to shares and the option to gather all at once. Let's make it simple. Think about one side at a time? What do I mean by that? Well, we're going to focus first on the stock. Just given the fact that the stock is going to be the primary focus of this question. We got shares of stock that the investor really wants to gain value over time and we happen to have this option here that's going to act as insurance. In case something goes wrong me to get the market goes down. We got insurance. Cool.

444.4s
So here's the system and by the way, you can use the system for any hedging or income strategy. When it comes to the maximum potential gain, the maximum potential loss questions, September one is think about the stock burst. The stock is actually going to set the stage for the way you. Look at the question. What do I mean by that? Well, maximum game, let's think about that first two to the lens of the stock. If I buy stock in 53, the maximum gain Market make money at the market goes up and the markings, go up forever. There's no ceiling to the market. So, technically, the maximum gain on a stock position, would be unlimited great. That's step number one is setting the stage for we're, we're, we're looking at the market, Maxima game for us, will be when the market price Rises. And again, there's no ceiling to the market, and what kind of think of it that way

502.6s
But we can't forget about the option. Okay, Second Step. This is the last step is working to figure out the option in that scenario. If the market price would arise, which would be maximum gain for the long stock position if that were to occur, what happens to the option.

519.7s
Well, there's a couple ways we can drive it that we never one is we can use the term, call up, put down one of my favorite terms. When it comes to options. What call up and put down will tell you is whether an option has intrinsic value and whether that option will be exercised, well put down put down, we meet if the market price Falls below the strike price of a put the put has intrinsic value and it will get exercised. Otherwise, it will just expire worthless. So we can go back to the original, the mindset that we have gate or think what the stock maximum game would be the market when the market price Rises. Well, if the market prices rising, the put is going to expire worthless.

569.4s
Again we can think about the put down part of it so we can just think about it. Conceptually let's say the market price would rise to a thousand. Would we want to exercise are put, which gives us the right to sell stock 50 when we could sell in the market for a thousand know, that would make any sense. So, here's what I'm trying to say is that we make more money as a market price Rises, and if the market prices anywhere above 50, departures going to expire. So we have to put that together as a concept and what's our maximum gain Unlimited?

602.9s
Now, this is one of the drawbacks and limitations of the T chart if he answers them limited, there's really, we're not really going to get any closure when it comes to the T chart. How do you plug in a limited into a number base system? And figure that out? Nor do? I think it's possible. That's why it's important for you to not only understand the numbers, but also the concept behind these strategies. Now, we're going to maximum loss, we will start the same way we bought the stock for $53 per share, and we bought the option for $3 per share for a total of 56 on the minus side. That's where we start.

642.2s
Now, for maximum loss, we're going to think about the same exact way we did with maximum gain. Well, let's think about what the stock through the lens of the stock first. That's how we're going to. Look at this, if the market price for the fall, that's when we have maximum loss on stock position. And in fact with long, stop worst case scenario, we know 10. If I buy stock for 53 in the market, price goes all the way down to zero, I've lost my entire investment. So that's where my maximum loss will be. And that's kind of sets the tone for the way we look at maximum for this entire strategy about where would maximum loss be for us, would be at the market price Falls to zero.

686.3s
At the second step we have to bring the option into the fold, okay? If the market was Falls 20 but there is the option going to be exercised. Put down, put down market prices below 50, put down the option, has intrinsic value, and it's going to be exercised. Are we in that scenario? Yes, we are.

709.5s
And hopefully as a concept that should make sense given that this is our insurance based strategy if B C D. Stock would have become worthless market price Falls the way down to zero. Hey we've got some protection here.

722.2s
We should act resizer, put Cellar, stock at 50 and we'll plug 15 to the T chart on the plus side for selling and in the stockroom.

732.0s
Now, some of you might be wondering, what, what did we exercise? The option? Should I plug 50 into the option bro? They're well you would plug something into the option, bro. On the left hand side. If we were to sell the option to a closing sale, but given the fact that the option gives us the right to do something with a stock. I plug this into the stock portions a t-chart. So, again, will place at 50 on the plus side on the stock, bro, and that is the end of our teacher. That's it. We just need to add up the numbers. Now, we have a 50 on the plus side great. And on the minus side, we have a three on the option, 53 of sockeye 56 in the money side and then we just kind of nothing ever got together at 50 in the +. 56, on the minus side, believes his with 6 left over on the minus side, which tells us our maximum lost is $600.

785.5s
Perfect. That's how I used to teach art.

789.1s
Great. Let's go ahead and reset again, will continually reset. It would go to new questions and we still have 53 for buying the stock and three for buying the option woken. Everything else should be cleared out. Now, break even for hedging and income. Strategies is one of the main selling points that utilizing a t-chart. And I'll show you on the show me the shortcut first. And then I'll show you the longer way to think about it will break even foreign investors when they're not making, or losing any money. And for us theoretically with a t-chart that would be when we have the same number on both sides.

828.2s
We have the same number coming in, the same number coming out, that that's that's when we're at break even so the question for us really is it what price does the stock need to go to in order to have a balance out teacher when we have the same number both sides?

846.1s
Thinking probably figure that out, right? There's only one number that can go on the left hand side, the side of the stock Road. It's blank. They can give us a balance out t-chart in that is 5656, is a Breakeven.

860.8s
Easy. Right now, here's some more conceptual way. And I would really hope that you understand the concept behind it because they test questions can be a little bit more complicated than just say, hey, what's the break-even?

872.6s
156. We have to make sure we understand what's happening there. Okay, when it whenever someone engages in the hedging strategy in order to break, even they have to make back the amount of money they spent on their insurance on the action, right? So the investor spent $3 per share $3 premium, I'll be put in a half and make that money back, just to break even. And how do they make that money back? Well, if we exercise the plate, that's not going to make us the money back, right? In fact, we already know what happens when we exercise to play. If we exercise the put Zoe's, soccer 50, that's maximum loss, right? So break, even for us, is going to be when the stock makes back the exact same amount of money we spend on the premier

921.2s
and the only way that's going to happen is if the market price Rises,

924.7s
If the market price goes up to 56 from 53 to 56, the investor has made $3 per share on the stock position in at $3 per share. They made on the stock Position will offset the amount of money they spent on the option.

940.8s
That's the one way to think about it.

943.4s
Either way works. Let's go ahead and restart RT chart again. So I bought the option for 3 about the stock 53 will start again. The bottom two questions are asking us to think about a scenario. What happens if the market price close to 40K? What's our gain or loss of the Marquess goes to 40. So thank you that. Okay. Or do you think about it almost the same way, we've been thinking about maximum gain the maximum loss. So it's 40. That's not great. For the stock. I buy stock at 53 market. Price falls down to 40. So $13 per share loss there. Okay? We're not terribly thrilled about that.

983.4s
But we have to make sure we understand what's going to happen with the put right at 40. Put down the option is in the money has intrinsic value and it makes sense for us to exercise the option.

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Why would we want to sell the stock in the Market at 40 when we can exercise, help putting save some money in sell the 50?

1005.5s
This is me feel pretty similar to our maximum Austin area. So it's 40. It makes sense why we want to exercise are put or exercise to put in Stellar stock at 5250 on the plus side. In the stock grow out of the numbers, 50 on the plus side, we have a 56 of them I decide we met at the numbers and meet up with a six on the minus side what are gained or lost it 40. It's a $600 loss.

1032.7s
Perfect.

1034.5s
All right, let's go to the last part of this question here. Gain or loss at 90, will think about it the same way market, price Rises, the 90, that's great.

1049.4s
What is that? I think it's $37 per share gain $3,700 we make is the market price Rises. So that's that feels pretty good, but we can't forget about the put 90. You think about up there is the put in the money out? The money? Is it going to exercise? Is it going to be a Spire? Well let's think about what down again. 90 put down, put only get exercise at the market. Price is below the strike price, we're well above the strike price, so our put, which gives us the right to sell at $50 in that we just bought some insurance. We didn't end up using

1088.9s
So this tells us hate the market price goes, 290 in Marana, close everything out. We're just going to sell our stock in 90 and let the put expire great. So we put a 90 on the plus side on the stock, bro, and that's the end of the T chart that we just happened. That other numbers, leave a 90 on the plus side, we end up with a 56 on the minus side together. If we met those together that will leave us with a 34 left over on the plus side. This is a $3,400 gain at the market price for the rise tonight.

Tyler York

15 Nov 2022, 17 min read