Hedging

[nazia]

Hello,

I wonder if anyone can help with a question I have. (This is theoretical btw)

I have 5000 shares in BSkyB.
Stock Price on 9th March - 436.50

With a strike price of 430:
Price of a March Call:19.5
Price of a March Put: 13

With a strike price of 440:
Price of a March Call: 14
Price of a March Put: 13

Each contract is for 100 shares.
I want to use these options to hedge my position.

My understanding is the below:
Buy 50 Put option contracts with K = 440 – Price paid = 50*17.5 = 875

S1 = 27th March Stock Price

If S1 > K, I do not exercise the option contracts and lose 875.

If S1 < K, I exercise the option contacts and gain ___

OR

Sell the stock now and receive 5000*436.50 = 2,182,500.

Buy 50 Call option contracts with K = 430 – Price Paid = 50*19.5 = 975

If S1 > K, I exercise the option contracts and gain ___

If S1 < K, I do not exercise the option contracts and buy the stock back in the market and make a profit of ___

1. Am I right in thinking this?
2. Which would I choose and why?
3. Would it be better to use a combination of the puts with different strike prices?
4. Would it better to use a combination of puts and calls?

I am very new to this and would appreciate any help! Its confusing me a little

Thanks!
Nazia

 

[anley]

Nazia

I wouldn't get involved with options if I were you, you'll get taken to the clearners, if only on the bid-offer spreads. They look easy to understand but they are very very complex.

Do you also realise that hedging basically means locking in a set price, so if the market goes up or down you won't lose, but you can't win either. Otherwise everyone would hedge and have zero downside, only upside.

As you're buying options this will cost you money so theoretically it's very easy for you to lose on both sides of the trade, ie you buy puts and the market drifts lower, the puts lose value going to 0 and the stock also loses value.

Or the stock climbs in value a touch, the puts expire worthless but you're still in the hole bcause the stock hasn't risen enough to pay for them.

The only way to hedge and get things right when buying options is if your timing is perfect, and always assume it won't be.

Finally, do you understand about option volatility and how that effects option prices, and I mean REALLY understand it? If you don't then you're driving the bus blindfolded which means it's certain it will crash.

Again, options are very tricky. If I were you I'd do one of two things.

1) Realise that as you're buying stock and taking on risk you've got a good chance of being rewarded for it, but this comes with a downside, the stock might fall in value.

2) If you don't buy the stock and keep your money in the bank you're taking on no risk but then will be paid poorly for it, but you cannot lose.

We all want a bit of 1 (the upside) combined with 2 but the world don't work that way! So it's one or the other I'm afraid.

 

[nazia]

I completely understand what your getting at but this is actually just a university exam question and therefore assumes that timing is perfect!

So in view of this... what answer would I go for??

(Sorry, should've mentioned this before!)

 

[TheBramble]

What date is it 'today''?

What are the IVs on the options given?

What is the interest rate?

Confirm you are looking for a delta neutral hedge.

 

[nazia]

This was the question given:

On the 9th of March each group should buy a copy of the FT. For one of the stocks in
your Portfolio, use an available option contract (see the Equity Options table in the Financial
Markets section of the FT) or combination of contracts to hedge 5000 shares. Buy an FT on
the 27th of March and decide whether to exercise the option and compute the gains made
from this portfolio of 5000 shares and options. Evaluate whether the hedge worked.

The interest rate we are using is 1.93063.

I dont know what is meant by IV's or a delta neutral hedge.

 

[TheBramble]

March equity options expired on March 20th.

 

[nazia]

Is the question or my reasoning flawed?

 

[TheBramble]

The question leaves out too much information for an unambiguous decision on which strategy to go for to be made.

A pure hedge would be buy the Puts, pay the premium as cost, risking the gap between strike and current if it goes out as potential cost, and insulate yourself against a move beyond exercise.

A higher risk – higher reward hedge would be to sell Calls, benefit from immediate cash premium and use that as a cover against adverse.

Without knowing the IV, or your risk profile, you’re really in no position to calculate fair value for premium on either side and therefore you’re unable to take a view of relative expense on whether to sell or buy premium.

It’s not so much the question or your reasoning are flawed – more a case of it being inadequately precise for a real life response.

If you want a textbook response, you already have the answer.

 

[nazia]

Thanks, I guess it was just the textbook response that I was looking for. I dont think the lecturer is interested in a real life response. Just that we understand the way options work.

 

[Futures Trader 501]

Thanks, I guess it was just the textbook response that I was looking for. I dont think the lecturer is interested in a real life response. Just that we understand the way options work.

The definition of hedging is transferring risk. Not to take profit or hedge against profit. If that was the case, why farmers are not making million of dollars.

 

[nazia]

Is there a way I can use a combination of the two different priced puts to simulate a strike price of 436.50?

 

[gooseman]

sell calls on your stock

 

[ns1000]

Is there a way I can use a combination of the two different priced puts to simulate a strike price of 436.50?

Not really.

As other posters have said, all you really want to do is hedge the risk, not flatten the exposure. I would have though that the answer is buy some puts. The point of the exercise presumably is to see how different strike prices are affected by a move in the underlying, or to evaluate different strategies. You could buy a load of atm puts, or more out of the money ones, or buy puts and sell calls, or buy some puts and different strikes.

 

[nazia]

Ok, great, thanks for all the help!