Advanced Strategies with Options

Hedging Strategies

In this lesson, you’ll learn how to use options to protect your portfolio or specific stock positions through hedging strategies. We cover three main approaches: the collar, the covered call, and the risk reversal, each designed to manage risk while maintaining potential for gains.

The collar strategy combines a long position on an underlying (at least 100 shares of a stock like Tesla or an ETF like SPY) with a protective put and a short out of the money call. The put protects you if the price collapses, while selling the call generates a premium that fully or partially pays for the cost of the put. You remain protected in a crash scenario while still benefiting from price increases up to the strike price of the sold call. The call and put should typically have the same maturity, though this isn’t always necessary.

The risk reversal strategy, also known as synthetic long, involves buying an out of the money call and selling an out of the money put. By selling the put, you receive a premium that can finance the call purchase, creating either a debit or credit strategy depending on premium differences. This approach is useful when you’re bullish on a stock but don’t want to use all your capital or pay the full call premium. Out of the money puts typically have higher implied volatility than out of the money calls due to higher demand for protective puts.

For the collar setup using the Q models, you could use the core resistance as the short call strike and the high volume level or closest put support level as the long put strike. For risk reversal, use core resistance as the long call strike and high volume level or closest put support level as the short put strike. The collar works best with stable JAX, stable cumulative JAX, and stable VAX, while risk reversal favors stable or bullish JAX, bullish cumulative JAX, and stable VAX.

Video Chapters

  1. 00:00 – Introduction to hedging strategies
  2. 00:40 – Understanding the collar strategy
  3. 02:06 – Collar payoff and profit/loss calculations
  4. 03:22 – Collar checklist and setup with Q models
  5. 03:52 – Risk reversal strategy explained
  6. 05:30 – Risk reversal payoff and checklist

Key Takeaways

  1. The collar protects your long stock position by combining a protective put with a covered call that finances the put cost
  2. The risk reversal creates a bullish position by buying an out of the money call and selling an out of the money put to offset costs
  3. Use core resistance for call strikes and high volume levels or put support levels for put strikes when setting up these strategies
  4. Both strategies require understanding of JAX, cumulative JAX, and VAX conditions for optimal implementation
Video Transcription

[00:00:00.24] - Speaker 1
In this lesson, we will focus on hedging strategies. These are strategies that aim to protect a specific position on a stock or the entire portfolio. Let's see what they are in the next slide. Hedging strategies allows us to use options to protect our portfolio or the exposure to an underlying. Here we have the long put or buying a put.

[00:00:20.10] - Speaker 1
Then we have the caller. In this strategy, we have a long position on a stock or underlying, an out of the money cover call and an out of the money put. We then have the COVID call or the sale of a call on an underlying held in the portfolio. And finally, the risk reversal. This consists on buying an out of the money call and selling an out of the money put.

[00:00:40.25] - Speaker 1
It's a combination of a long call and a short put. We have already talked about the long puts, so let's start with the caller. Let's go. In this strategy, we have a long position on a stock or underlying. We have long and out of the money put and short and out of the money call.

[00:00:56.38] - Speaker 1
To protect an underlying or portfolio, we have the put. With the purchase of puts, we are able to fully or partially protect the exposure or a portfolio. However, this protection has a cost that sometimes can be very high to finance all or part of the cost of the put. A strategy that is often used by investors is the color. The color has these characteristics.

[00:01:16.57] - Speaker 1
First is the long position on the underlying. In this case, I own at least 100 shares of a stock, for example Tesla or an ETF like SPY in my portfolio. The second step is the purchase of a protective put or a long put. Finally, the sale of an out of the money call where the price is higher than the spot price. In this case, we are selling a cover call.

[00:01:39.08] - Speaker 1
In this strategy, the put can protect us if the price of the underlying collapses. Selling the call can help us to receive a premium that should fully or partially pay for the cost of the put. We are protected in the event of a crash and we can still benefit from a price increase of the asset till the strike price of the sole call. The call and the put should have the same maturity, but it is not necessary in all cases. The caller is a strategy widely used by investors who are long stocks and want to protect their risk.

[00:02:06.02] - Speaker 1
Let's look at the payoff. In this example, we are long a stock that we bought at $50. We hold 100 shares and our exposure is $5,000. We want to protect our position from a possible collapse and buy a $45 strike put. At the same time, we sell an out of the money call with a $55 strike.

[00:02:24.59] - Speaker 1
Lets assume that the net cost or debit of this strategy is $1. This is the difference between the cost of the put and the premium received for selling the call. The maximum profit is $400 and is calculated as follows. We bought 100 shares of the stock at $50. We then sold the call at $55.

[00:02:42.59] - Speaker 1
So if the price goes above $55, our call will be exercised and we would sell 100 shares at $55. The profit then would be $500. We paid a net debit for this strategy for $100 or $1 times 100 shares. This is why our maximum profit is $400. The maximum loss is $600.

[00:03:02.16] - Speaker 1
If the price of the underlying falls below $45 at expiration, we bought the stock at $50 and the put at $45. We are protected if the price falls below $45. So we have a $500 loss here. Then we need to add the net debit of $100, which is the cost of the strategy. Now let's look at the checklist.

[00:03:22.14] - Speaker 1
Here we want a stable jax, a stable cumulative JAX and a stable vax. In this case, we don't want too much volatility or a high bullish or bearish movement. Finally, the setup Using the qmodels, we could use the core resistance as the short call strike and the high volume level or closest put support level as the long put strike. Now let's move on to the last hedging strategy we will cover in the course known as the risk reversal. The strategy consists of buying an out of the money call and selling an out of the money put.

[00:03:52.21] - Speaker 1
It's a combination of a long call and a short put. By selling the put option, the trader receives a premium which can be used to finance the purchase of the call. If the cost of the call is higher than the premium received for the sale of the put, this strategy will have a cost or a debit. On the other hand, if the sale of the put generates a higher premium than the purchase of the call, we have a credit strategy. This strategy is also called synthetic long as we have a bullish view on the underlying.

[00:04:17.47] - Speaker 1
But instead of buying shares, we use options. When using the risk reversal, we must understand the Greek and the skew. Out of the money puts typically have a higher implied volatility than out of the money call options. There is a higher demand for protected puts. We are therefore selling options with a higher implied volatility and buying options with the lower implied Volatility traders typically use this strategy by betting on the change in the skew or volatility surface.

[00:04:41.53] - Speaker 1
We can use the risk reversal when we are bullish on a stock but we don't want to use all of our capital to go along the underlying or we don't want to pay the full premium of the call. By selling the put, we can receive the premium that can partially or totally finance the purchase of the call. If the market has bottomed out, we can benefit from the increase in value of out of the money calls. If a stock has suffered large losses, we can implement this strategy with the medium term time horizon. We could achieve significant returns if the stock bounces back and takes momentum upwards.

[00:05:11.37] - Speaker 1
This strategy has the advantage of being a low cost strategy and can offer attractive returns if the market moves. It is also a strategy that involves risk should the underlying continue to fall. Let's look at the payoff of the risk reversal strategy. In this example we are interested in a stock that is trading at $50. We believe the stock will move up.

[00:05:30.10] - Speaker 1
We buy an out of the money call at $55 and sell an out of the money put at $45. Let's suppose this strategy as a $1 net debit. The breakeven price in this case is represented by the strike of the call plus the debit paid or $56. The maximum profit is unlimited. The maximum loss can be high and is represented by the difference between the put strike and zero.

[00:05:51.38] - Speaker 1
If the underlying fall is below $45 at expiration, we have to buy 100 shares for a total exposure of $4,500. If the stock goes to zero, we will then lose all of our exposure. Now let's look at the checklist we we want a stable or bullish jax, a bullish cumulative JAX and a stable vax. And finally the setup using the Q models. We could use the core resistance as the long call strike and the high volume level or closest put support level as the short put strike.

[00:06:20.03] - Speaker 1
This is the end of the lesson on hedging strategies.