To Hedge, or Not to Hedge?

Aye, that is the question. Option players often choose to create spread trades rather than pure bets on a stock going up, or down, over a set period of time. Spreads provide a predetermined maximum risk, combined with a well-defined maximum upside potential. It's comforting to know those boundaries in advance, but with comfort comes expense. Assume we like the prospects for shares of Griffon Corp. and want to place a bullish bet on the stock. GFF closed on Feb. 13, 2019 at $17.91. Based on the real life quotes above, we could sell some July 19, 2019, expiration date $17.50 puts for $1.65 per share. At the same time, we could buy an equal number of GFF's July $15 puts for $0.85 per share. Here's what the cash position would look like if these trades were executed in a margin-type account using pre-existing buying power to meet the margin requirements. We would have collected a net $800 on the 10 contracts (ignoring commissions) as the higher strike price put we sold more than paid for the $2.50 lower strike price put that was purchased. Fast forward to expiration day. At 4 PM on July 19, 2019, if GFF closes below $17.50, we'd be on the hook to buy 1000 shares via the $17.50 put being exercised. We'd need to lay out $17,500. Unless we'd withdrawn the original credit from the trade, we could use the $800 already collected to lower that net amount to $16,700. We would now own 1000 GFF at a net start-to-finish outlay of $16.70 per share. Every stock has a theoretical risk of going to zero. Without a hedge in place, the worst-case risk of owning 1000 GFF shares @ $16.70 would be $16,700. Remember, though, we bought 10 $15 puts at trade inception. No matter how low GFF had sunk, we could exercise those options and force somebody else to take the shares off our hands for $15,000. So far we've only covered the bad things that could happen with GFF. Suppose our bullish feeling was justified. In that case the stock would still be north of $17.50 on expiration day. Keep in mind that Griffon was over $17.50 the day we started. Those puts will expire if the stock goes sideways, up, or even slightly down over the duration of the option selected. That covers a lot of possibilities. The net credit collected up front was $800 ($1,650 came in while $850 went out). If both puts expire worthless, the ones we shorted and the ones we bought, we'd keep that $800 and be all done. So, the best-case result on this credit spread is a gain of $800. But the worst-case loss was $1,670. Even though it's the most likely result, I don't find that risk/reward ratio very tempting. Why was the maximum payoff so small? $850 of the potential gain on the expired $17.50 put sales went to pay for the downside insurance (purchase of the $15 puts). If we'd forgone that term insurance policy and simply shorted the $17.50s our maximum gain would have been $1,650. That's more than double the $800 best case win on the spread. Hedging is expensive. In most cases, you're paying dearly for insurance you're not likely to need. If you're truly worried that a stock might really 'blow up', why play with that underlying share at all? There are thousands of companies to choose from. Buying hedges for your option trades is similar to purchasing extended warranties on small appliances or travel insurance, just in case you don't make it to your cruise ship before it sails. Small, bearable risks don't really need to be covered. Only major risk factors, which would be hard to survive, like home or car insurance, should usually be insured. Insurance agents live off of the heaven forbid sales technique. If your investment strategies are sound, though, the money you get from the occasional claim on trade insurance is almost certain to be less than you've paid out over the long term. I've been successfully trading unhedged options for almost forty years now. I know from my own experience that I've saved a ton of money by passing up the protection. That's my two-cents on this issue. I'm sure many readers and options traders will disagree with me.

To Hedge, or Not to Hedge?

Hedging a stock can be expensive for investors and not always worth it.

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