Hedge option trading

First, let me say this: Most people lose money trading options.
It’s a very difficult game. But if you can find an edge, the returns can be huge. One of the best option-trading hedge funds in the business, Cornwall Capital, has averaged 51% annualized over the past 10 years. That turns a mere $20,000 investment into $1.2 million, in less than 10 years.
Two of the best option strategists that have ever worked on Wall Street are Keith Miller, formerly of Citigroup, and John Marshall, of Goldman Sachs. Both Miller and Marshall happen to be Blue Jays (i. e., Johns Hopkins University grads), like me. If you can ever find any of their research studies, print them out and examine them closely. They are excellent — and will give you an edge.
Below are the rules the best hedge funds use when trading options:
Options are like a coin toss; you’ll be lucky if half your option trades are profitable. That is why you have to make sure you get paid for the risk you take.
Only trade an option if your projected return is a triple or better. To do this you will have to buy an out-of-the-money option. And you should go out at least two months, preferably longer. Now, here’s the math:
Let’s say you make 40 option trades a year. Odds are at best you will only make money on 50% or half of these trades. Therefore, if you had 40 options trades and 20 of those trades expired as worthless, and the other 20 option trades averaged a triple or more, you would still make 50% a year. For example, on a $40,000 account taking 40 trades a year, if 20 option trades lose everything and the other 20 trades give you an average return of 200%, your account would be worth $60,000, giving you a 50% return.
So $20,000 would go to zero on the option trades that expired worthless. The other $20,000 would go to $60,000 on a 200% return.
Price predicts a stock’s earnings and fundamentals 90% of the time. According to Keith Miller of Citigroup, a stock will start to move one to two months ahead of its earnings date, in the direction of the earnings report. This means if a stock starts trending higher or breaks out higher before the company reports earnings, the earnings report will be positive 90% of the time.
When you are buying options on a stock, make sure the stock is owned by an influential investor or activist. These investors, such Carl Icahn, Barry Rosenstein of Jana Partners and the rest, are always working behind the scenes to push the companies to unlock value; this can come in the form of incremental positive change or big one-time catalysts. This positive announcement or catalyst usually emerges after the stock has moved up in price. So when you see an activist-owned stock breaking out, or trending higher, there is usually a good chance change is coming. Thus, you’ll want to buy calls on this stock immediately.
Only trade an option if there is an event or catalyst that will reprice the stock. This could be an earnings announcement, a company’s Investor Day or an annual meeting.
Only buy options when both implied volatility and historical volatility are cheap. Be a value buyer of options. Watch volatility. Buy volatility only when it’s cheap.
A perfect example of an option trade that fits all of the above criteria is Walgreens ($WAG).
> Jana Partners, run by billionaire Barry Rosenstein — one of the top 5 activist hedge funds on the planet — owns more than $1 billion of Walgreen’s stock. That’s more than 10% of the fund’s overall assets invested in Walgreen’s (Jana has $10 billion under management). Even better, they just added to their position last week, buying $77 million more during the market correction.
> Walgreen (WAG) just broke out of a consolidation pattern, and it looks like it is ready to make a big run (see chart below).
> Walgreen reports earnings on December 22nd. So whichever way the stock moves over the next month or two will predict whether the company’s earnings are positive or negative. Based on the stock’s current price momentum, the report will be positive.
> The Walgreen $65 calls are cheap, especially since they expire only two days before the company reports earnings. You can buy the Walgreen December $65 calls for just $1.10. That means, at $66.10 or higher, you will make money on this option. My price target for Walgreen, based on its recent breakout, is $69. That also happens to be where Walgreen gapped previously.
> If Walgreen stock trades just 10% higher to $69 by December 20th, you will more than triple your money on this option in less than two months. This is the risk-reward profile you want when trading options. Your goal should be to make 50% a year.

Hedging With Options.
2.1 Financial Statements 2.2 Taxes 2.3 Capital Cost Allowance And Depreciation 2.4 Cash Flow And Relationships Between Financial Statement.
4.1 Net Present Value And Internal Rate Of Return 4.2 Capital Investment Decisions 4.3 Project Analysis And Valuation 4.4 Capital Market History 4.5 Return, Risk And The Security Market Line.
You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.
The other function of options is hedging. Think of this as an insurance policy; just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way.

Using Hedging in Options Trading.
Hedging is a technique that is frequently used by many investors, not just options traders. The basic principle of the technique is that it is used to reduce or eliminate the risk of holding one particular investment position by taking another position. The versatility of options contracts make them particularly useful when it comes to hedging, and they are commonly used for this purpose.
Stock traders will often use options to hedge against a fall in price of a specific stock, or portfolio of stocks, that they own. Options traders can hedge existing positions, by taking up an opposing position. On this page we look in more detail at how hedging can be used in options trading and just how valuable the technique is.
What is Hedging? Why do Investors Use Hedging? How to Hedge Using Options Summary.
What is Hedging?
One of the simplest ways to explain this technique is to compare it to insurance; in fact insurance is technically a form of hedging. If you take insurance out on something that you own: such as a car, house, or household contents, then you are basically protecting yourself against the risk of loss or damage to your possessions. You incur the cost of the insurance premium so that you will receive some form of compensation if your possessions are lost, stolen, or damaged, thus limiting your exposure to risk.
Hedging in investment terms is essentially very similar, although it's somewhat more complicated that simply paying an insurance premium. The concept is in order to offset any potential losses you might experience on one investment, you would make another investment specifically to protect you.
For it to work, the two related investments must have negative correlations; that's to say that when one investment falls in value the other should increase in value. For example, gold is widely considered a good investment to hedge against stocks and currencies. When the stock market as a whole isn't performing well, or currencies are falling in value, investors often turn to gold, because it's usually expected to increase in price under such circumstances.
Because of this, gold is commonly used as a way for investors to hedge against stock portfolios or currency holdings. There are many other examples of how investors use hedging, but this should highlight the main principle: offsetting risk.
Why Do Investors Use Hedging?
This isn't really an investment technique that's used to make money, but it's used to reduce or eliminate potential losses. There are a number of reasons why investors choose to hedge, but it's primarily for the purposes of managing risk.
For example, an investor may own a particularly large amount of stock in a specific company that they believe is likely to go up in value or pay good dividends, but they may be a little uncomfortable about their exposure to risk. In order to still benefit from any potential dividend or stock price increase, they could hold on to the stock and use hedging to protect themselves in case the stock does fall in value.
Investors can also use the technique to protect against unforeseen circumstances that could potentially have a significant impact on their holdings or to reduce the risk in a volatile investment.
Of course, by making an investment specifically to protect against the potential loss of another investment you would incur some extra costs, therefore reducing the potential profits of the original investment. Investors will typically only use hedging when the cost of doing so is justified by the reduced risk. Many investors, particularly those focused on the long term, actually ignore hedging completely because of the costs involved.
However, for traders that seek to make money out of short and medium term price fluctuations and have many open positions at any one time, hedging is an excellent risk management tool. For example, you might choose to enter a particularly speculative position that has the potential for high returns, but also the potential for high losses. If you didn't want to be exposed to such a high risk, you could sacrifice some of the potential losses by hedging the position with another trade or investment.
The idea is that if the original position ended up being very profitable, then you could easily cover the cost of the hedge and still have made a profit. If the original position ended up making a loss, then you would recover some or all of those losses.
How to Hedge Using Options.
Using options for hedging is, relatively speaking, fairly straightforward; although it can also be part of some complex trading strategies. Many investors that don’t usually trade options will use them to hedge against existing investment portfolios of other financial instruments such as stock. There a number of options trading strategies that can specifically be used for this purpose, such as covered calls and protective puts.
The principle of using options to hedge against an existing portfolio is really quite simple, because it basically just involves buying or writing options to protect a position. For example, if you own stock in Company X, then buying puts based on Company X stock would be an effective hedge.
Most options trading strategies involve the use of spreads, either to reduce the initial cost of taking a position, or to reduce the risk of taking a position. In practice most of these options spreads are a form of hedging in one way or another, even this wasn't its specific purpose.
For active options traders, hedging isn't so much a strategy in itself, but rather a technique that can be used as part of an overall strategy or in specific strategies. You will find that most successful options traders use it to some degree, but your use of it should ultimately depend on your attitude towards risk.
For most investors, a basic comprehension of hedging is perfectly adequate, and it can help any investor understand how options contracts can be used to limit the risk exposure of other financial instruments. For anyone that is actively trading options, it's likely to play a role of some kind.
However, to be successful in options trading it's probably more important to understand the characteristics of the different options trading strategies and how they are used than it is to actually worry specifically about how hedging is involved.

What Is Hedging?
Definition Of Hedging.
Hedging in financial terms is defined as entering transactions that will protect against loss through a compensatory price movement.
Hedging - Introduction.
Hedging is what seperates a professional from an amateur trader. Hedging is the reason why so many professionals are able to survive and profit from stock and option trading for decades. So what exactly is hedging? Is hedging something only professionals like Market Makers can do?
In fact, hedging is not restricted only to financial risks. Hedging is in all aspects of our lives; We buy insurance to hedge against the risk of unexpected medical expenses. We prepare fire extinguishers to hedge against the risk of fire and we sign contracts in business to hedge against the risk of non-performance. Hence, hedging is the art of offsetting risks.
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How Do Traders Perform Hedging?
In the simplest form, hedging is simply buying a stock which will rise as much as the current stocks would fall. If you are holding XYZ stocks which is already profiting and you want to protect that profit if XYZ should suddenly fall, then you would buy ABC stock, which rises $1 if XYZ drops $1. In that way, if XYZ company falls by $1, your ABC company stocks would rise by $1, thereby offsetting the loss in XYZ company.
Hedging Stocks Using Stock Options.
Hedging a portfolio of stocks is easy and convenient using stock options. Here are some popular methods:
Hedging In Option Trading.
Option traders hedging a portfolio of stock options or hedging an option position in an option trading strategy, needs to consider 4 forms of risk. Directional risk (delta), how directional risk will change with stock price changes (gamma), volatility risk (vega) and time decay risk (theta). Yes, these are the Option Greeks. These risks are factors that influences the value of a stock option and measured by the Option Greeks. Option traders do not normally perform hedging for interest rate risk ( rho) as its impact is very small. Hedging a stock option portfolio requires understanding of what the biggest risk in that portfolio is. If time decay is of concern, then theta neutral hedging should be used. If a drop in the value of the underlying stock is of greatest concern, then delta neutral hedging should be used. All these hedging are done in accordance to the hedge ratio.
Why Don't Some Traders Practise Hedging?
Some stock or option traders regard themselves as long term investors who buy and hold for the long term in order to ride an overall long term gain in the stock markets, ignoring short term and mid term fluctuations. These traders completely ignore hedging under the false sense of security that the stock markets will rise over time without fail. While that may be true over the long term of about 20 to 30 years, short term ditches of up to a couple of years do happen and destroys portfolios that are not hedged. Not hedging in this sense is akin to not buying accident insurance just because you always cross the road obeying traffic rules. Does that guarantee that unforeseen circumstances won't happen?
Spreading is a hedging technique that uses stock options in the hedging of stock option risks. Unlike delta neutral or contract neutral hedging strategies which uses also the underlying stock sometimes in the hedging of directional risks.
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Every single risk attributed by the option greeks can be hedged by putting on more short option positions. As stock options of different expiration date and strike prices will have different combinations of the option greeks, there is an unlimited number of ways by which one can perform spreading on one's stock option portfolio.