Is This a Hedge?

Fifty Ways to Trade an Option

There are a couple of key words in options trading that are subject to a lot of interpretation.

If your accountant isn’t going to recognize those trades as income, it’s worth questioning if you should too. The premium received from covered calls also isn’t rent, yield, or other tantalizing financial-ish terms.

Writing a call option against your stock holdings might not be that, but it is a hedge. Another frequently misapplied word. A buy write is an asymmetric hedge, with only a dab of premium coming to net on the downside, and 100% offset (i.e. flat Pnl) above your short strike. How much you get paid for giving away that offset is the implied volatility premium.

Wrap a collar around the whole position with a put buy, and you have what is the most absolute of all option hedges. Assuming no changes in dividends you’re basically set dollar for dollar in stock price movement. More discussion on that here: How to Put on a Collar and Tailoring Your Hedges.

Every other structure as a hedge is a vastly greater degree of subjective. Adding complexity to a position almost certainly increases risk. And as you wade into correlations or betas as a hedge, there’s also the chance you can lose both ways.

It’s true you can’t hedge perfectly, because you can’t make money that way. The etymology of the two and twenty moniker comes because these funds could be hedged and still generate returns. The reality is sometimes they are hedged, and sometimes they make money.

What kind of options hedge to implement will depend on your use case. Go to the buttoned up collar extreme if you need to freeze the underlying asset’s value. But whether you want something that mimics every movement of your core position or just coverage in a specific scenario depends on the strategy.

One nice feature of a hedge is convexity, which is why investors like to use options as a hedge. If you can put some curvature on your payout, it’s less of a drag on returns in the good times. Throwing a ratio on your 1x3x5 will get you there too, but a classic position to achieve this multiplier effect is the butterfly. (Which is a sort of hedge within a hedge - buying the wings in a long butterfly caps the risk of a straddle.)

Butterflies are offered cheaply, allow you to target trading range, and show a very tempting payout. Today in Fifty Ways to Trade an Option, we’ll discuss - is a butterfly a hedge?