Learn to hedge your options trades (FINRA SIE, Series 7, 65, 66)

Tyler York

We teach you how to use hedging strategies in your options trading to limit your risk. This is both useful for retail traders and a key options topic tested on FINRA and NASAA exams.

If you’re looking for a comprehensive course to pass your FINRA or NASAA exam the first time, try Achievable’s FINRA and NASAA courses. We offer courses with industry leading pass rates for the FINRA SIE, Series 6, Series 7, Series 63, Series 65, and Series 66 exams. Try a free Series 7 practice exam to get a sense for our questions.

Full Learn to hedge your options trades (FINRA SIE, Series 7, 65, 66) video transcript:

Let's do a quick overview of what to expect with hedging strategies. What they are. How investors use them, what are the pros and cons of utilizing these types of strategies in our portfolios? Whenever you think of the word hedge, I would love if you would replace that word in your head with protection, or even the word in shreds, a hedging strategy is an insurance based strategy where we are utilizing a long option to protect a stock position. It's kind of interesting, whatever we come across these. Multi-part strategies with option, we're always going to feel like we're putting together, two things that are kind of opposites and we'll see that thing over and over again. But we're going to keep going back to the term insurance and using that as a metaphor, or an analogy, for what's going on in this type of strategy, I think that'll help us overall put the big picture together. There are two primary types of hedging strategies that we need to be aware of for the example, the first one is long stock.

Long. But let's think about the big picture just with stock. We want the market price to go up buying low and selling high with a long stock position is what we hope to do in the higher. The market goes the better, that's the good of it. The bad of long stock is we could buy today and the market price could fall, technically all the way down to zero. And if it were to fall 20, we would be at our worst possible point or maximum loss position with a long stock position. For example, if I buy stock at 50 in the market, price goes all the way down to zero, I've just lost $50 per share, and although it's relatively uncommon or rare for that to happen, it does there's tons of companies that have been publicly traded to have gone out of business. Rare is maybe a little bit of both strong term. That maybe it's just more on the more Uncommon side of things. And with that thought process in place, let's think about why.

We have a long, put long puts our options that give us the right to sell. 100 shares of stock at the fixed strike price, at least until that option expires. It is a bearish strategy on its own right. If I buy a plate from the same thing, I'm hoping that the market price Falls. So, for example, if I have a 50 put market price Falls to say 20, I can go to the market, buy stock at 20 exercise, my put and then sell that stock at 50, make a profit by doing so. The problem with thinking that way, is the fact that we have a long stock position and that's part of the mix here and just going to kind of mess up the way we think of a long. But if we're berishen along put in the market, price Falls,

That's not good for a long stock position. Now, again you said this up front, we have two conflicting strategies here or just two conflicting positions, we have bullish long stock in a bearish long, but

The one put gives us the right to sell why we place a bear strategy with a bullish long stock position? The primary reason is it we're not really bearish. We're just utilizing the long put as a form of protection or the way to ensure ourselves. So again, let's say that we buy 100 shares of stock at 50.

Thinking again about that risk market price Falls all way down to zero. That's really what we're contending with was we were to purchase a 50 put or go long, a 50 but that would mean that as long as we have the long put in place and it hasn't expired yet, we always have the right to sell stock at 50 if I buy stock at 50.

Do I want to sell that stock at 50? No. And on top of that, if I buy the put we we have to remember that that's not a free strategy there. That's not a free-position. Want to pay a premium to obtain that put just like any other form of insurance that we pay for insurance. But we don't actually want to use the insurance

And think about any type of insurance that you have good, you have it, but you probably don't want to use it. If you don't have to, have you ever woken up on any random day? And today, I can't wait to use my car insurance later today.

Now, that's the wrong puts role. In this strategy here. We want to see the long stock position rise. If we buy stock in 50 we want to rise 202. Wondered a thousand the higher up, it goes the better.

But the long put is there to allow us to exercise the option in case the market price for the fall and that's believe the theme of the way you want to think about a hedging strategy. The investor focus is the one stock position. They will make money at the market price Rises and they will lose money at the market price Falls. But the long put there is to protect them from losing more money than they would have. If they didn't have the put in our example here, the long put will be exercised if the market price Falls below the strike price and if we know call up put down that should probably reinforce that idea, right?

Put down market price Falls below the strike price in the put the put has intrinsic value is going to be exercised. So let's put all those ideas together at once. Now, with this type of hedging strategy, if the market price Rises goes up, we make money in the stock position, the put wall expire worthless because it'll be out of the money at the market prices, anywhere above the strike. Price and example, if it's above 50,

And we're happy with that.

That's like getting car insurance on your car and never getting in an accident. Did we pay for car insurance? Yes, did we use it? No, or we bummed about not using it? No, no, it was insurance.

But if the market price Falls below 50, let's see if it goes all the way down to zero. Hey, our insurance is there to protect us in to prevent us from losing more money than we would have. Otherwise, technically, anytime the market price is below 50, it gives us the incentive to utilize the option to exercise the option.

And we will the other hedging strategy is short stock paired with a long call option. And again, we will focus primarily on the stock position. Here, short stock means that we have borrowed stock from a broker-dealer sold, it immediately, and we're hoping that the market price of that stock Falls, so that we can then by that. Stock back later, let's say they were short 100 shares of stock at 80. We hope that the market price Falls all the way down. Technically, you know the further it falls the better Falls to 4030 2010 0

Zero would be, our best case scenario borrow stock at 80 sell it at a tea, goes all the way down to Zero by that stock back. That's worthless. And then give those shoes back to a broker-dealer, that's how short stock position works for, for hoping to buy back that stock at the lowest possible price and 0 is the lowest possible price. The only problem with the shortstop position is, it gets bad at the market price Rises

So we short stock at 80. What happens if the market place close to 120 140 to 1 through 300 400 the higher, the market price goes the more expensive. It is for the investor to buy back that stock to give those shoes back to their broker-dealer and that's how short socks Edition works. That's why short stock positions. If there are unprotected subject the investor to unlimited risk-retention. Now the long call that's our protection long calls, give the right to buy stock at, they fix dry price at least until that option expires. So, if we sell short stock at 80 and we also buy an 80 call.

That means we have protection at a tea, of course, that won't call. Just going to cost some money. The premium that will have to pay will hurt a little bit but if the market price would rise substantially, that's a goes up to 150, 200 300

Be much better to exercise our call by back, that's talking, 80, even with the cost of the premium, instead of not buying the option, watching the market price, rise, significantly and having to buy back to that much higher price later again, put the put the big picture together on the short stockmann call position. This is a bear strategy together all the way down, hopefully 20.

And if that's the case, hey, we make a bunch of money are soccer position for able to buy back a much lower price. Of course, we spent money on the premium of the long call that's going to cost us something. We're okay with the long call expiry and going out of the money.

Call up, put down, call up that calls only going to get exercise at the market price Rises. So get at the market price Falls, anywhere below 80 in our example here, then we're just going to let that call expire. We didn't use our insurance, but at the market price of a rise, anywhere above 80, we're going to exercise that call buy back our stock at 80 and hopefully lose less money with our insurance. Then we would have otherwise busy the theme how it relates to insurance.

Think of the premium, just like the premiums you pay on your car insurance. No one wants to use our car insurance and if you had to use car insurance, you understand it. Unless you have really good insurance, you're probably paying high premiums on. If you eat allies, your insurance will probably lose some money. Anyways, that's going to be the problem with both of these strategies will the long put protective wall stock from losing any money at all. Know what the long call protective shorts opposition from losing any money? No, in both cases, if the long put is exercise with a wang stock of the long cause exercise with the shortstop position, if we utilize our insurance the investor is going to be losing some amount of money. But if the market has moved significantly against the stock position, most likely the losses that we would have incurred without the option

They may have been much bigger and that's the way to look at these strategies from a big-picture perspective. These strategies help investors protect themselves from significant losses that they would have incurred without the option that they had and the options there made roll, there is to protect the stock position. And if you're asked ever, what's the market sentiment of this hedging strategy, just follow the stock position? If we're longstock low put, longstock is bullish. That is a bull a strategy if we're short. Stock long call short stock is a bear strategy when the market price to fall or bearish there or not making money with the options. We hope we don't exercise the options there, just purely there for insurance and we'll use that insurance if we need it.
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