Option Strategy Explanation 01|How to potentialy profit from the SVB crisis through options investing.
Option Strategy Explanation 02 |How to amplify the return through the option strategy
Hello！
Let's start with a question: If you hold shares of a company but are worried about a potential future decline in the stock price, what would you do? Generally, there are two solutions:
1.Sell the stocks, but you risk missing out on potential future gains if the stock price rises.
2.Buy put options as a hedge against the downside risk, but there is a cost associated with this hedging (option premium).
Is there a method that can hedge the downside risk without incurring any hedging cost?
The answer is yes, and this is where the 「long double-limit combination」 strategy comes into play.
1. What is long double-limit combination
In the American television series 《Billions》 there is a plot： the trader Mafee is instructed by his boss to sell 5 million shares of Bluudhorn Steel at a price of $40 per share.
However, such a large sell order would have a significant impact on the market, and the stock price would undoubtedly decline. Mafee may not be able to sell all of his shares at the desired price of $40 per share. According to the dialogue in the series, they estimate the potential loss from the decline to be in the tens of millions of dollars.
To avoid such losses, the investment genius Taylor proposes using a zero-cost collar strategy.
This involves buying put options on Bluudhorn Steel with a strike price of $40 while simultaneously selling call options with a strike price of $45. Combined with the stock holdings, this creates a collar strategy.
In essence, this zero-cost collar strategy is what we refer to as long double-limit combination strategy.
As mentioned earlier, when we fear a decline in our stock holdings, we can choose to buy put options to hedge the downside risk. However, buying put options incurs a cost.
To offset this cost, we can sell a call option. As long as the premium received from selling the call option is equal to the premium paid for buying the put option, it theoretically creates a zero-cost option strategy.
This effectively provides insurance against the downside risk of your stocks at no cost. However, while the concept of this strategy is simple, the actual implementation involves considering various complex factors. Now let's take Alibaba（BABA） as an example and discuss the practical steps.
2. How to proceed practically
Currently, Alibaba's stock price is around $82. If we are concerned about a potential decline in the stock price before June 2nd, we can choose to purchase put options with a strike price of $82 and an expiration date of June 2nd. The cost of the option premium would be $1.73. Additionally, we can sell call options with a strike price of $85 and receive a premium of $1.50.
But the question is:
It is indeed a challenge when the premium paid and received are not equal, making it difficult to achieve a zero-cost hedge. However, this is an inevitable issue due to the nature of put options having a lower strike price, making them more expensive, while call options with higher strike prices are relatively cheaper. Since the premium paid will always exceed the premium received, how can we address this?
One possible solution is to adjust the number of contracts involved.
For example, if the put option premium is $2 and the call option premium is $1, you can purchase 100 put option contracts while simultaneously selling 200 call option contracts. This way, the cost of purchasing put options would be 100 * $2 = $200, and the premium received from selling call options would be 200 * $1 = $200, balancing the expenses.
Similarly, if you hold 1,000 shares of Alibaba stock and need to hedge against downside risks by purchasing 10 put option contracts, the total cost of the premium would be $1.73 * 100 * 10 = $1,730. Theoretically, the premium received from selling call options should also be $1,730. By reverse calculation, the number of call option contracts to be sold would be 1,730 / 100 / 1.5 = 11.53 contracts. Rounding it off, you can choose to sell 11 or 12 call option contracts to achieve an approximate zero-cost hedge.
While this strategy allows for a zero-cost hedge, it is important to note that it also has certain drawbacks. What are these specific limitations?
3. The drawbacks of the long double-limit combination strategy
1. Risk of Stock Price Increase
The long strangle strategy only hedges against the risk of stock price decline. However, if the stock price increases but does not surpass the strike price of the call option, it will not impact the overall profitability. Once the stock price exceeds the strike price of the call option, the sold call option starts to incur losses, potentially offsetting or even exceeding the gains from the stock price increase, resulting in an overall loss for the portfolio.
2.Inability to achieve Absolutely Zero Cost
As mentioned earlier in the Alibaba example, it was calculated that selling 11.53 call option contracts would generate $1,730 in premium to offset the cost of purchasing the put options.
However, in practical trading, the number of option contracts must be a whole number. If we round down to 11 contracts, the premium received would be less than the cost paid. If we round up to 12 contracts, the premium received would be more than the cost paid. Therefore, it is only possible to approximate zero-cost hedging.
But overall, learning the "Long-double limit combination strategy" can not only provide insurance for the stocks in hand for free but also enjoy the upward returns of the stocks within a certain range. There are many benefits. Have you learned it?
OK. If you want to learn more about options, feel free to follow our detailed course, "Introduction to Options." We will continue with further explanations.
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