36 lines
2.9 KiB
Plaintext
36 lines
2.9 KiB
Plaintext
Orapter 4: Other Call Buying Strategies 123
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THE REVERSE HEDGE (SIMULATED STRADDLE)
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There is another strategy involving the purchase of long calls against the short sale of
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stock. In this strategy, one purchases calls on more shares than he has sold short. The
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strategist can profit if the underlying stock rises far enough or falls far enough dur
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ing the life of the calls. This strategy is generally referred to as a reverse hedge or sim
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ulated straddle. On stocks for which listed puts are traded, this strategy is outmoded;
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the same results can be better achieved by buying a straddle (a call and a put).
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Hence, the name "simulated straddle" is applied to the reverse hedge strategy.
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This strategy has limited loss potential, usually amounting to a moderate per
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centage of the initial investment, and theoretically unlimited profit potential. When
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properly selected (selection criteria are described in great detail in Chapter 36,
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which deals with volatility trading), the percentage of success can be quite high in
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straddle or synthetic straddle buying. These features make this an attractive strategy,
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especially when call premiums are low in comparison to the volatility of underlying
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stock.
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Example: XYZ is at 40 and an investor believes that the stock has the potential to
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move by a relatively large distance, but he is not sure of the direction the stock will
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take. This investor could short XYZ at 40 and buy 2 XYZ July 40 calls at 3 each to set
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up a reverse hedge. If XYZ moves up by a large distance, he will incur a loss on his
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short stock, but the fact that he owns two calls means that the call profits will outdis
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tance the stock loss. If, on the other hand, XYZ drops far enough, the short sale prof
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it will be larger than the loss on the calls, which is limited to 6 points. Table 4-2 and
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Figure 4-2 show the possible outcomes for various stock prices at July expiration. If
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XYZ falls, the stock profits on the short sale will accumulate, but the loss on the two
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calls is limited to $600 (3 points each) so that, below 34, the reverse hedge can make
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ever-increasing profits. To the upside, even though the short sale is incurring losses,
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the call profits grow faster because there are two long calls. For example, at 60 at
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expiration, there will be a 20-point ($2,000) loss on the short stock, but each XYZ July
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40 call will be worth 20 points with the stock at 60. Thus, the two calls are worth
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$4,000, representing a profit of $3,400 over the initial cost of $600 for the calls.
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Table 4-2 and Figure 4-2 illustrate another important point: The maximum loss
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would occur if the stock were exactly at the striking price at expiration of the calls. This
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maximum loss would occur if XYZ were at 40 at expiration and would amount to $600.
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In actual practice, since the short seller must pay out any dividends paid by the under
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lying stock, the risk in this strategy is increased by the amount of such dividends. |