Risk-Reduction Strategies

You can use options not only as speculative strategies but also as ways of
locking in profit, insuring investments, and reducing the risk of loss of
current investments.

Two common scenarios in which sophisticated investors have learned
to utilize the risk-reduction properties of options are:

• When an investment has proved successful and the investor
has a large, unrealized profit-Although the investor is still bullish
on the stock and/or does not wish to pay the taxes that would be
due on the gain were he to sell the stock, the investor is nervous
about the stock in the short term. This concern might involve an
upcoming earnings report, the outcome of litigation, or some other
news event. How does the investor ride out this rough patch?
• When an investor is considering initiating a new investmentThe
stock has just experienced a significant sell-off: perhaps due to a
general market decline. The investor believes that this situation is
most likely a short-term situation and that the stock should recover
most of its recent loss. There is the possibility, however, that this loss
is not the bottom (which might be much lower). Jump in now or wait
-that is the dilemma.

Additionally, we will explore a strategy known as a risk collar/
fence, where we will analyze the cost of purchasing the protective puts by
selling OTM calls.

Protecting Unrealized Profit
An individual investor who owns a stock that has appreciated since its
purchase has an unrealized or paper profit. Ifthe investor wants to maintain
this position because he or she believes that the stock might continue
to rise in price, he or she is then exposing himself or herself to directional
market risk. Ifthe stock goes up, that is good. If it goes down, that is bad.
Not only is his or her unrealized profit at risk, but his or her initial capital
is also in jeopardy.

If the investor is concerned about short-term down-side risk but is not
interested in selling the stock, he or she has three choices:
1. Do nothing and hope for the best.
2. Place a stop order.
3. Purchase a put in order to protect his or her position. The put establishes
a minimum amount that the investment will be worth. Essentially;
the investor is purchasing insurance to protect his or her capital
and unrealized profit. The put strike price will determine how much of
the profit and capital that the investor wants to protect. The expiration
month ofthe put will determine the period in which the insurance
will be in effect. The price of this insurance varies based on these two factors.
When comparing stop orders to puts, we find the following advantages:

• Puts cost money, but stop orders are free.
• Puts expire, but stop orders stay until you cancel them.

The disadvantages of stop orders, however, are
• Stop orders do not protect against stocks gapping down in price,
whereas options work wonderfully in that situation. There are two
types of stop orders: limit and market. Consider this example. A
stock is trading for $100, and you place a stop order at $95. If the
stock suddenly gaps below $95, your result will depend upon
whether your order is limit or market. If your order is market, then
your stock will be sold at whatever price to which the stock gaps
down. If your order is limit, then if the stock gaps down below your
limit, nothing will happen. If the limit is below the post-gap price,
however, the stock will be sold. Unless you expressly specify that
your stop order is limit, it becomes a market order when the stock
trades at or below the stop price.

• If your stock drifts down towards your stop order price, it will automatically
trigger a sale once the stop price is reached. With a put,
you have the luxury of waiting to see what the stock does with the
knowledge that you can exercise your option at any time prior to its

Let's now examine the use of puts in more detail. Here is the simple
formula for calculating the protected profit of the position:
Put strike price - initial stock purchase - put price = protected profit
In this example, the individual investor had purchased 100 shares of
stock for $85-an $8,500 investment. The investor was right, and the
stock increased in value. The stock is currently trading at $105-a $2,000
profit. The investor believes that the stock might continue to rise in price
but is currently concerned about downside risk. Maybe there is currently
a bearish sentiment in the market, an earnings report, or a news item.

The investor is looking to protect not only his initial capital, but also his
unrealized profit. The investor does not want to sell the stock for several
reasons: first, he might believe that the stock will rise even further in the
future. Second, he might not have held the stock for one year and is concerned
with short-term capital-gains tax consequences.

The investor decides to purchase the May 105 puts and pays $4 ($400)
for the right to sell stock at 105 by May expiration. By purchasing the put,
the investor has protected his initial investment of$8,500 and some ofhis
profit. By using the following formula, we can calculate exactly how much
profit the investor has protected:

Married Puts
Often, an individual investor considers purchasing stock-believing that
the stock will increase in value over time-but is concerned about a shortterm
and possibly negative situation. In this situation, the individual
investor wants to protect his or her position. A possible solution is the
married put.

A married put results when stock and puts are purchased at the same
time. The married put position gives the purchaser a downside stop until
the put option expires. For this strategy, the ATM or OTM puts are purchased,
depending on how much downside stop loss the trader is willing
to incur. This strategy is used when purchasing a stock in a volatile situation,
such as upcoming earnings, news events, and so on-where you
believe that the potential reward is substantial but the downside risk is
significant. Here is the formula:
Stock price - strike price + put price = maximum loss

Notice that the married put has the same profit and loss graph as a
long call. Remember that long puts plus long stock equals a long synthetic
call. Why not purchase the call instead, then? This question is a
good one. One answer might be that the price of the synthetic call might
be cheaper than the price at which you can purchase it directly. Another
situation that might call for the use of the married put involves the uptick
rule. In order to prevent opportunists from exacerbating a market
panic by selling stock short while the market is collapsing, the Securities
and Exchange Commission (SEC) instituted a rule that only gives short

sellers the right to sell when a stock trades up from its last trade (an uptick
in price). Someone who is selling stock that they own is not a short
seller. In a market panic, the holder of a married put could sell his or her
stock without being limited by this rule. Ifyou owned the call instead, any
attempt to sell short would be subject to this rule. For this reason, many
professional traders trade married puts and conversions in order to assure
a supply of long stock for those occasions when it is useful to sell stock in
a market meltdown.

Risk CollarlFence
Usually, when the investor wants to protect his or her long stock position
by purchasing puts, he or she is concerned about a volatile event in the
marketplace. This event could be any number of concerns, and unfortunately,
the investor might have the same idea as many other people in the
marketplace. This situation adds to the rise in the implied volatility of the
options. With an increase ofimplied volatility comes the increase in options
premiums. This situation causes the OTM put that the investor was interested
in purchasing for protection to rise in price. In some cases, the premium
rises to a point where it might not be advantageous to the individual
investor to purchase. When this situation happens, the individual investor
must find a way to finance his or her insurance policy (the put).
The risk collar/fence strategy might be the alternative that the
investor needs. This strategy enables the investor to purchase the put and
finance it with the sale of a call.

In the case of long stock, the investor is looking to purchase an OTM
put and finance the OTM put by selling the OTM call.

Long Underlying Security (Risk CollarlFence)
Buy an OTM put and sell an OTM call. (The OTM call sale finances the
OTM put purchase, which is the down-side protection for the underlying
security.) Figure 9-61 illustrates the profit and loss associated with a risk

The position is similar to the bull spread. The purchase ofthe put and
the stock has created a synthetic call, therefore giving the investor the
same characteristics as the bull spread.

The risk collar has enabled the investor to lock in limited risk and
reduce the put premium by selling the call. The short call with the long
stock has created a similar risk-versus-reward profile as for a covered
call. The individual investor has limited his or her upside potential with
the sale of the call.

Short Underlying Security (Risk Collar)
Buy an OTM call and sell an OTM put. (The OTM put sale finances the
OTM call purchase, which is the upside protection for the underlying
short security.).

The risk collar/fence can also be used to protect short stock. In this
case, the individual investor is purchasing OTM calls to protect the short
stock position from a rise in stock price. The OTM put is sold in order to
finance the OTM call purchased. This situation creates a similar riskversus-
reward profile as for a bear spread. The short stock and long call
have created a synthetic long put position.
You should note that all ofthese positions have synthetic equivalents.
Read More: Risk-Reduction Strategies

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