The Value of Good Hedging

A significant number of investors fail to hedge their portfolios for two reasons: They are unaware of hedging strategies or they implement them poorly. Hedging is a very important strategy that can help increase returns in one's portfolio offering income and protection during market corrections. For example, if you had purchased Netflix on the day of its earnings release last week, you would have seen a 10 per cent hair cut on your share price. However, I made the same purchase and hedged fully and have made gains on the trade. Here's how.

Before I provide you with the trade details, readers must know that my strategy on Netflix is an income generating strategy and not of capital appreciation and therefore the strategy outlined ahead may not be suitable for all investors. My intentions on buying Netflix is to collect the premiums on covered calls while ignoring the daily and weekly oscillations in the stock price. This way of thinking mimics a home owner renting their property to a family as the value of the monthly rent trumps the value of the home. The value of a home could rise or fall, but the rental income is the primary focus on the investment. With that said, here's how I've made money on a losing trade.

Shares of Netflix were purchased for $99.39 a share. Immediately, a married put strategy was implemented selling the July 22 103 call for $3.30 a contract. We also purchased a July 22 95 put for $2.93. As you can see, the premiums received on the calls offset the cost of the put option. The paired trade automatically generated income of $37 a contract regardless of where the stock finished for the week. This represents 0.37 per cent income on investment. The set up above meant that I would be forced to sell my shares at $103 if the stock rose above on Friday. However, if the stock fell below $95, I would have the option to sell at $95. My max profit on the stock was $3.61 a share and my maximum loss was $4.39 a share.

With the shares having fallen to around $86 on the stock's earnings report, the put option was sold for $9.80 instead of selling the stock at $95 because I wanted to continue owning the shares and reduce commission costs. The call option was worthless and we collected the entire $2.93. With the shares below the Bollinger Bands, we knew a rise was imminent, and on Tuesday July 26, the shares rose back above $90. We sold the July 29 93 call for $0.65.

If you add up all the transactions, the net money collected through all options was $10.82 (sale of call and put options minus the cost of the put option) a share dropping our break-even to below $90. If we are forced to sell the shares at $93 before the end of the week, we will have actually made $4.43 a share even though we sold it for $6.39 below our purchase price, as we see in the table below.

Asset Name	Cost Price	Sale Amount
Netflix stock	99.39	93.00
Jul 22 103 call	0.00	3.30
Jul 22 95 put	2.93	9.80
Jul 29 93 call	0.00	0.65
Total	102.32	106.75

I have removed commission costs in the examples above, however, with commissions below $5, they're essentially negligible in this example. If you have comments or questions on hedging strategies, leave us a message or follow my Facebook trading page Moonlight Financial Education.

Disclaimer: I am currently long Netflix shares and short Netflix call options.