What's Your Call on Hedging?

A couple of weeks ago, we talked about what must seem like a very counterintuitive concept: protecting oneself from downside exposure using call options. This week, we will delve into this topic more deeply with an actual example so you can understand the economics behind this type of transaction. We'll also review the various ways to protect one's downside exposure about which we've written during the past few months.

Call Protection--Real Life Examples
Recall that using calls as protection means that you do not "overlay" a stock with an option but rather buy the option outright (or sell the stock to buy the option). Let's take a look at two examples that compare the price and protection of protecting one's downside using a call versus using a put overlaid on a stock. In both examples, I have taken actual market data for  Wal-Mart (WMT) and have priced long-term equity appreciation securities, or LEAPS, which are long-tenor options, with 20 months left before expiration on Wal-Mart.

In the table below, I am looking at call options struck at $55 (Wal-Mart was trading at $55.41 as of this writing). On the top row, in the first four columns from the left, I show the total cash expenditure for buying Wal-Mart's call option with a $55-strike price (I use the convention of cash outlays being negative and cash inflows being positive). In this case, we do not have an outlay to buy the stock; we just have to spend money to buy the call. As such, our total outlay using this strategy is just $4.75--the cost of the call option. In the first four columns of the second row, we show the total cash expenditure for buying Wal-Mart's stock, then purchasing a protective put on it.

Obviously, because we are buying the stock and the option, our cash outlay is much higher (nearly 13 times higher) for this mode of protection. But remember that holders of dividend-paying stocks get dividends, whereas holders of options on dividend-paying stocks do not. As such, to make a fair comparison, we should factor in the dividends the stockholder receives into our cash outlay calculation. You see the result of this calculation in the last column--the cash outlay for the call option protection strategy stays at $4.75, but the cost of the protective put overlay goes down by the amount of the expected dividend to $59.53. (By the way, it turns out that call option holders not receiving dividends is not as unfair as it might sound at first. If Wal-Mart did not pay a dividend, its $55-strike call would have been priced higher by about the expected amount of the dividends. In other words, the buyer of a call option on a dividend-paying stock gets his dividend up-front, in the form of a discount on the price of the call.)

 Source: Morningstar Analysts 

Even factoring in the value of the dividend, protecting one's position using calls wins hands down if we look at it from a cash-outlay perspective. However, recall that in my previous article, I wrote about using in-the-money calls (calls whose strike prices are well below the market price) as hedging tools rather than at-the-money calls as in the example above. Let's take a look at the same Wal-Mart example, this time focusing on the purchase of $45-strike options. After looking at this example, we'll compare and contrast the two approaches.

Source: Morningstar Analysts

Here, because we are paying for a deep in-the-money call option, the cash outlay is higher than before--$11.55. On the put-overlay side, our cash outlay is less because the put option is further out-of-the-money, so it has less probability of paying off. So in this case, the cash outlay for the ITM call option is much higher than for our ATM call option above. Why then do we recommend the ITM call options over the ATM ones then? There are two reasons, the first of which involves something called leverage. I have written a series on leverage for Morningstar OptionInvestor, titled, "Leverage Is Not a Dirty Word," and readers interested in learning about where leverage comes from and its implications for investing are encouraged to take a free trial of our newsletter and read the entire three-part article.

In brief, ITM options offer less leverage than ATM options, which in turn offer less leverage than OTM ones. Leverage is important because the more leverage one has on an investment, the greater one's unrealized gains and losses are going to be for a movement in the underlying stock. For instance, a long-tenor option on a low-volatility stock will fluc­tuate in value by let's say 1.5%-2.0% for each 1.0% move in the underlying stock (in options jargon, this effect is termed "percent delta"). An ATM option's percent delta on the same stock might be twice the ITM amount, and the percent delta on the OTM option could be twice or even more than that of the ATM one! For most conservative investors, the greater volatility of the options is frustrating and might be a bit off-putting; as such, we recommend the less volatile call options for hedging.

The other reason one would hedge with an ITM option rather than an ATM one is that the probability of your owning the stock at expiration increases the further ITM you buy your option. In other words, if a stock is trading for $55 now, the chance that it will be trading for $45 or more in 20 months is higher than the chance that it will be trading for $55 or more over the same time horizon. So assuming you like the stock and want to keep hold of it, the ITM options are a better choice.

Recapping Option-Based Protection Strategies
We have spent the last four articles talking about various option strategies an investor can use to protect his portfolio. In the chart below, I've summa­rized each of these strategies, their strong and weak points, and things to consider when entering into them.

A version of this article originally appeared in the July 2011 edition of the Morningstar StockInvestor newsletter.

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