Generating a little extra premium when your hedges expire

by Wayne Ferbert on June 26th, 2012

Our book was published in October of last year. So, if you bought it in the October 2011 quarter and are following our strategy, you have been hedging now for anywhere between 6 to 9 months. Since we recommend that you build your hedges with a rolling 6-month outlook, you might now have hedges that are expiring.

Most of the time, hedges expire out of the money. So, if you are going to remain invested, you roll your hedge to a new strike price with a new expiration date that is around 6 to 9 months from today. We refer to that as ‘rolling our hedges’.

But what do you do if your hedges are expiring in the money? In our book, we only really examine what you do if you are closing your position. You take your profit from your protection and walk away from the position. But we don’t address what to do if you are planning to stay invested in the position. Shame on us – as it is the key to producing long-term out-performance.

Staying invested in the position is a very common outcome – especially if the position is part of your asset allocation strategy. We should have addressed it in our book. In fact, we should have addressed how staying invested can often lead to better compounded returns.

If your hedges are in-the-money at expiration (ie, the price of the underlying has gone below the downside protection level you set), you need to re-invest the ‘gains’ from the hedge in to the underlying investment. In other words, you need to take the opportunity to buy the underlying at its low point. This is like an automated way to making sure you are dollar-cost averaging.

You remember dollar-cost averaging, right? It is where you keep buying more shares as a stock goes lower – with the plan that your investment hypothesis will be right at a future date. You now own even more shares than you originally planned when you dollar-cost average in your positions as the shares go down.

Think about the approach: If an ETF that is part of your asset allocation is trading at $50 and you buy a hedge (maybe a put) at $45 strike that expires in 6 months. Fast forward six months and say the ETF is trading at $40. The hedge is about to expire and it is $5 in the money ($45 put minus $40 market price). With the hedge in the money, you effectively stopped losing money on the ETF at $45.

The ETF is trading at $40 but your total position in the ETF is trading at $45 – because the put protected you. When the put expires, you will want to exercise it and sell the ETF to the party that sold you the put. But what if you plan on holding on to this ETF since it is part of your asset allocation strategy.

We recommend an approach that gets you buying more shares when the price is down. We recommend you instead close the put position right before expiration. You should be able to get close to the full $5 in profit by closing that position. Now, you are sitting on an ETF position with a price of $40 per share and $5 per share in cash (ie, the proceeds from t he put you sold).

You need to re-invest the $5 of cash to buy more shares of the ETF. This way, you own more shares of the ETF – and the new shares you purchased you have bought at the $40 price. This is a great example of the dollar-cost averaging. If the ETF recovers, you will own more shares than you started with.

We see an opportunity to generate some extra time premium here. If you have a hedge that is set to expire that is in the money, you must be prepared to buy more shares with the profit from the hedge. Why not sell a put that expires at the same time as the hedge – that way you are forced to buy more shares AND you collect some time premium in exchange for locking in your purchase price.

A few rules to follow when you sell the put:
  • Sell the put at a price that is below the hedged price protection
  • Sell this put with anywhere from 2-6 weeks left before expiration – not when you originally created the hedge
  • Sell only as many contracts as the profit from the hedge would fund for you to purchase

The last point above is the key point. You don't sell the same number of put contracts as you own in protection. Otherwise, you'd be closing your protection.

Let’s use the ETF example from above that was priced at $50 with protection at $45. The ETF finally was trading at $40 at expiration. Let’s say that with 4 weeks left, the ETF was trading around the $41 mark. You could easily sell the $40 put. Remember that you own the $45 put as your hedge – so you are not selling this put in a naked position.

Instead, you are saying that for X number of contracts, I will give up my protection below the $40 price. You are effectively saying, you would be willing to buy X times 100 more shares at the $40 price. In other words, you are automating the dollar coast averaging and getting paid some premium to do it. So, the question is, how do you calculate the X number of shares?

It is simple really. The difference between the $40 price you sell the put and the $45 protection level is a $5 difference. The calculation is the $5 difference divided by the $45 protection level. In this case, it would be 11%. IN other words, you should sell the put equal to roughly 11% of whatever the current position you own is. In this case, if you owned 1000 shares and had 10 contracts protecting it, you would sell one contract (just round down or up as needed).

So, when the time comes, you can use the nature of options to your advantage to get paid to do something you would have done anyway – dollar-cost averaged your way to a portfolio with more shares owned – that was funded by the profits in your hedges!

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