August 04, 2016
Concentrated Stock Positions: Considerations and Strategies | Hedge your position
Hedge your position
You may want to try to protect yourself in the short term against the risk of a substantial drop in price. There are multiple ways to try to manage that risk by using options. However, bear in mind that the use of options is not appropriate for all investors.
Buying a protective put essentially puts a floor under the value of your shares by giving you the right to sell your shares at a predetermined price. Buying put options that can be exercised at a price below your stock's current market value can help limit potential losses on the underlying equity while allowing you to continue to participate in any potential appreciation.
However, you also would lose money on the option itself if the stock's price remains above the put's strike price. Selling covered calls with a strike price above the market price can provide additional income from your holdings that could help offset potential losses if the stock's price drops. However, the call limits the extent to which you can benefit from any price appreciation.
And if the share price reaches the call's strike price, you would have to be prepared to meet that call. A collar involves buying protective puts and selling call options whose premiums offset the cost of buying the puts. However, as with a covered call, the upside appreciation for your holding is then limited to the call's strike price. If that price is reached before the collar's expiration date, you would not only lose the premium you paid for the put, but would also face capital gains on any shares you sold. Be careful about closing one side of the collar while the other side of the trade remains outstanding. For example, if you exercised the put but the shares you sell are later called away prior to the call's expiration date, you could be left with an uncovered call. You could potentially suffer a loss if you had to repurchase the shares at a higher price to fulfill the call.
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