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Three Ways You Can Hedge Stock Into Earnings

Jeff BishopJeff Bishop ·

Consider this scenario: A swing trader buys Tesla shares in January of 2017, when the stock was trading around $225 per share. Now, with the stock trading north of $310 per share, and earnings around the corner, they are wondering if there is a way to protect their stock gains and hedge.

 

 

The answer is yes. In fact, here are three basic strategies that do just that.

Covered Write

A covered write is a combination, of a long stock position and short call option. When you sell a call option you have the obligation to deliver the stock if called upon. However, since the trader is long the stock, they are covered.

This example should clear things up if it sounds confusing:

Let’s assume the trader bought 500 shares of Tesla for $225 per share. With the stock closing at $314 on Friday, April 28th; and earnings on May 3, the trader decides to look at how the market is pricing Tesla options.

Now, before an earnings announcement, there is a lot of uncertainty surrounding the event, the stock could move big (in either direction). Of course, that expected volatility is priced into options.  

The May $320 calls are priced at around $6.60. Now, if this trader sold 5 of these contracts, they would collect $3,300 in premium.

But how does it affect their position. By selling the calls, they are willing to sell their shares, as they get exercised on their options.

In addition, it gives them some small downside protection. With the stock trading at $314.07, if you subtract $6.60, they are protected all the way down till $307.47.

Now, if look at this trade closely, it’s clear to see it’s not a good one. The trader is giving up way too much upside and just partially hedged.

However, the options that expire on June 9th have much higher premiums.

Source: Yahoo Finance

For example, the trader could sell the $330 calls for $8.90. With five contracts, they are collecting $4,450 in premium. However, they also make if the stock price rises, they won’t be of risk on getting called on the stock until it gets past $330 a share.

In addition, they will be protected down towards the $305 level if the stock does sell off.

Does this trade make sense?

Well that is up for you to decide and what trading is all about, weighing in the pros and cons, and making a decision.

If you don’t think it’s not enough upside and not enough downside protection, how about the next strategy…

Married Put

A married put is another combination trade, it involves a long stock position and a long put option. Buying a put works similar to paying for insurance, there is a premium paid, but you’re covered if something goes wrong.

Source: Yahoo Finance

The May $310 puts are priced at around $7.30, if the trader buys these they will be spending $3,650 on five contracts. That is the most that they can lose on the entire position. On the other hand, if Tesla gains 20 points after the earnings release, the trader would have made an additional $6,350, and still be long the stock. That number was derived by the stock gain, and then subtracting the cost of the put options.

What about going further into a different month, or selecting a different strike price?

Yes, tinker around, analyze the risks and rewards, then select the one that makes the most since based on your view of the stock.

The last strategy we’ll look at is a mashup.

  1. Bull Collar

This position requires three legs: long stock, long put and short call.

The best of both worlds? That’s up for you to decide.

Source: Yahoo Finance

Let’s say the trader sells 5 of the May $330 calls for $3.50. In addition, they buy the $300 puts for $3.75. All together the cost of this trade is $0.25 (125 bucks in options premium)

Source: Yahoo Finance

So how can the trader make money with this trade?

Scenario: The stock goes up

If the stock goes to $330 they could get called on their short call. However, the trader would have made $8,000 from being long the stock.

Scenario: The stock doesn’t move

The trader just loses the premium, in this case $125 bucks.

Scenario: The stock sells off

If the stock were to drop to $300, the trader would lose about $7k, their put protection kicks in at that price level.

Risking $7k to make $8K, does that make sense?

Well, only if you think the odds of it moving higher are greater than 50/50. For example, if you bet $10k on Lebron James beating your friend in a game of one on one, would you do it if the the payout was only $500. Chances are that even with such a skewed payout, its free money that Lebron should win every time.

Summary

There are ways to hedge stock positions with the use of options. That said, there are an assortment of strike prices and expiration periods to analyze before making a decision. Make sure to examine what the upside and downside is, and whether or not the trade fits your risk parameter.

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