Investors aren't accepting anything short of perfection this earnings season. Apple (AAPL) - Get Apple Inc. Report and Yahoo! (YHOO) , among others, have seen their shares pummeled for not exceeding expectations, despite delivering double-digit earnings growth.
In light of this reality, investors might want to review their portfolios for stocks that could still be vulnerable, and consider ways to protect gains or profit from a sharp decline.
While selling shares is always the simplest way to reduce a position's downside exposure, people are often reluctant, for tax purposes or other reasons, to sell their stock holdings. Instead, they often turn to options for protection, specifically buying put options.
The problem with this approach is that it always comes at a cost, and if it's not properly applied it will prove ineffective. When looking for temporary protection, it's important to make sure the number and type of puts purchased will actually provide the amount and duration of insurance desired. Generally speaking, longer-dated options (those with more time remaining until expiration) with strikes deeper in-the-money will provide the most efficient hedge in terms of cost and protection.
What Level of SPF?
Understanding the concept of an option's delta is important in determining how much it will cost to gain a certain amount of downside protection.
Generally, at-the-money options have a delta of 0.50 (long puts are usually assigned a negative value to signify the bearish bent), meaning that for every $1 change in the underlying stock price, the put option's price will move 50 cents.
For example, if you were long 1,000 shares of XYZ Corp. at $50 per share, you would need to purchase 20 of the $50 puts to have full protection against a fall in the stock below $50. Of course, the cost of the puts will increase the effective purchase price of the stock by the total premium amount paid, which also represents the position's new risk or potential loss.
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The delta value is described on a slope, meaning that as an option moves into or out of the money, the rate of change increases and decreases accordingly. In the example above, what started as a delta-neutral or fully hedged position will become increasingly short or bearish as the price of XYZ declines below $50. Ultimately it would have a delta of negative 10, equal to being short 1,000 shares, if the stock price falls. If the stock price rises, the position grows increasingly long, potentially reaching a delta of 9.99, on the basis of 1,000 shares long. (Theoretically, the puts will retain some fractionally negative delta.)
This concept can be applied to adjust your protection so it matches expectations and risk profile for the market or for individual issues. For the example above, assume you wanted to limit the downside risk to prices below $45. You could buy 20 of the $45 put options, which (assuming about 60 days until expiration) initially have a delta of negative 0.25 because the puts' delta will increase to 0.50 when XYZ shares trade down to the $45 strike.
To be immediately fully hedged or delta neutral with the stock at $50 would require the purchase of 40 of the $45 puts. Another alternative would be to buy a lesser amount of the higher strike, knowing the delta will approach 1.0 as the calls move deeper into the money. For example, buying 12 of the $50 puts against the 1,000 shares will become a delta neutral or fully hedged position when XYZ hits $45.10 per share.
As these basic examples show, a position's delta is cumulative: It is the sum of all its parts' values at any given time and price. If you want to use a spread in which you buy a higher-strike put and simultaneously hedge a short, this will help calculate the strike prices and the number of contracts that should be used.
One reason to use a spread would be to minimize the impact of a change in implied volatility. When insuring against a event or news such as earnings, be aware that once the results are announced, implied volatility, and therefore the value of the related options, usually takes a dive, dampening the effectiveness of the long put option.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;
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