What are they?

Hedging and Option Strategies

Chapter 41Tools & Techniques of

Investment Planning

Copyright 2007, The National Underwriter Company 1

What are they?

• The Chicago Board Options Exchange defines hedging as “a conservative strategy used to limit investment loss by effecting a transaction that offsets an existing position”

• Hedging is a form of investment insurance.– It transfers risk from one person or entity to another.– Hedgers may have to pay a “premium” or be otherwise willing

to forgo potential investment returns to shift risk.



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What are they?

• The difference in perception between a risky strategy and a hedge depends on each investor’s:– Circumstances– Other investment holdings– View– Forecast of future events– Perception of market conditions



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What are they?

• Investors may employ hedging strategies and tools to reduce risk, or even “immunize” their investment holdings in stocks, bonds and other debt instruments, commodities, futures, and other investments against almost any conceivable risk.– Their scope ranges from those employed at the portfolio level

to the asset-class, sector, or industry level, to the individual security or investment instrument level.

– The time frame for employing them may range from same-day to overnight to years.



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What are they?

• Hedging involves:– “Tools”: Certain investment instruments– “Techniques”: Strategies

• In the “techniques” area, first and foremost are the fundamental principles of sound investing: diversification and asset allocation.– Investors can usually eliminate nearly all of the company-

specific risk of stocks, the security-specific risk of individual investment instruments, selection risk, and country-specific risk by diversifying and investing in a large number of securities within a given asset class, sector, or industry, and across a number of countries.



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What are they?

• In the “techniques” area, first and foremost are the fundamental principles of sound investing: diversification and asset allocation (cont’d).– Investors can further reduce their exposure to loss within a

given asset class, sector, or industry by allocating portions of their portfolio among different assets or asset classes whose returns are not highly correlated (or even inversely correlated) with each other.

• Many of the “tools” involved in hedging are “derivative” securities, such as options contracts, forward and futures contracts, and other derivatives.



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When is the use of such devices indicated?

• Investors want to protect current security values from price decline when they must make quick decisions with limited information.

• An investor is uncomfortable with a large percentage of value in a single stock (a concentrated portfolio) but does not wish to sell and trigger capital gains taxes at the present time.

• An investor has a large holding that is facing an almost certain dramatic movement up or down, but the question is which?



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• An investor may own a large position in a stock that has trading restrictions due to:– Initial Public Offering (IPO) lock-up provisions– Trading restrictions imposed by the government or the company due to

insider status or other factors

• An individual with a short life expectancy due to advanced age or illness (or as spousal beneficiary of a marital trust) may wish to protect against a decrease in stock or equity portfolio value (to protect the value of the assets for heirs), but may not wish to sell because the appreciated positions would receive a step-up in basis at death.– Substantial capital gains taxes would be incurred if sold before death.



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• An individual may be in need of liquidity for various cash flow needs but does not wish to trigger capital gains taxes.

• Investment advisers, trust officers, investment managers, or other fiduciaries responsible for other people’s money want to meet their fiduciary duty to protect the value of the total portfolio.– This can be facilitated by diversifying and hedging against

declines in value of their clients’ investments.



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How is it done?

• Fundamental Investment Principles:– Employing the sound investment fundamentals of

diversification and asset allocation is the best way for investors to reduce the risk of their investments.

• The single biggest contributor to an individual stock’s price volatility is its individual business risk (60% to 80%)

• This risk is unsystematic risk that investors can eliminate by diversifying into many companies rather than just one or a few.

• By diversifying into a number of companies, investors will earn the average return for the group, but with considerably less average return volatility than that associated with any single company within the group.



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How is it done?

– Investors can also manage the level of their exposure to systematic risk factors by diversifying across sector, industry, or asset classes.

• The process of asset allocation and portfolio management.• Different sectors, industries, and asset classes tend to respond

differently to:– Changing economic conditions– Periods in the business cycle– Various economic, social, political, and other major events

– When investors can fully employ these principles, the need to hedge investments in any particular security, group of securities, industry, or asset class becomes negligible and the cost engage in such hedges is generally prohibitive.



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How is it done?

• At any given time, for whatever reasons, investors might have a “concentrated portfolio” that they cannot or choose not to “fix” using the fundamental principles of investment and portfolio management.– A “concentrated portfolio” is a portfolio that is over-invested in

a particular security or asset class and, therefore, overexposed to risks associated with that investment.



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How is it done?

• In volatile markets, investors’ portfolios may quickly deviate from their preferred mix among asset classes and expose them to market and asset-class risk levels that they deem unacceptable.– Making adjustments all at once to move back to their preferred

asset mix and risk/return profile may be difficult and expensive as well as disadvantageous for tax purposes.

• Such investors should consider hedging strategies.



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Sales, Stop-Loss Orders, and Short Sales

• In many cases, simply closing out or selling a position is the best decision when an investor finds it necessary to diversify a security or asset class.

• Often investors can also sell loss assets in their portfolio to offset gains and neutralize tax effects.



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• Investors overexposed in a security or asset class cannot always be sure that:– They will recognize the need to rebalance, or– They will have sufficient time to “manage” the sale of the

position and offsetting loss positions before the appreciated position declines in value.

• Two relatively simply techniques that investors have to protect themselves from loss in these situations are:– Stop-loss orders– Short sales



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• Stop Loss Orders:– They are generally good-till-cancelled or standing orders with

brokers to sell (or buy) a security held long (short) if the price moves below (above) a specified value

– The problems with stop-loss orders are three-fold:• The investor has to or should reassess and reset the stop-loss

orders as the value of the position changes.• The broker will actually sell the position if the market price hits the

stop-loss price– The investor will be liable for tax on any gains realized

• Investors have no assurance that trades triggered by their stop-loss orders will take place at a price that is anywhere close to their stop-loss trigger price



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• Short Sales:– This strategy involves selling securities borrowed from a third party.

• In general, the investor’s broker or custodian arranges to borrow the securities from the margin account of one of its other customers.

– While short-sellers maintain their short position, they must reimburse the lenders for any dividends or interest paid on the borrowed securities

– If the securities decline in value, the short-seller may then purchase the securities on the open market at a lower price than the initial sales price

• The short-seller then returns the purchased stock to the third party and pays tax on the gain at long-term or short-term capital gain tax rates, depending on the holding period.

– If the short-seller closes out the short position by buying the securities after they have appreciated in value, the loss is treated as long-term or short-term capital loss.



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• Short Sales Against the Box:– Investors sell short securities that they also hold long in their portfolio.

• This technique offers perfect inverse correlation because gains or losses on the long-position are perfectly matched by losses or gains on the short position.

• As long as an investor maintains both the long and short position, the economic value of the investor’s position cannot change.

– This strategy was originally used primarily for tax timing purposes.• Now treated for income tax purposes as constructive sales, making them

much less attractive for hedging purposes.– Although investors can still use this technique to prevent economic loss

on an appreciated position indefinitely, they generally will have to realize their gain and pay tax on the appreciated long position in the tax year in which they enter into the short sale against the box.

• Long position receives stepped-up basis



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• Short Sales of Close Substitutes:– The investor selects a short sale involving securities of a

company in the same industry, which has a close, but not perfect, correlation to the securities the investor wants to protect.

• In general, even if closely correlated, short sales of a different company’s securities will not be treated as a constructive sale.

• Circumvents the currently unfavorable constructive sale rules for short selling against the box.

• Any time correlation is not perfect, a hedging strategy can fail.– Individual business risk is generally greater than the industry or market

risk.– Investors cannot use short-selling strategies to hedge perfectly against

company-specific events such as fraud or massive liability, unless they short that specific company’s securities.



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• Short Sale of Exchange-Traded Funds (ETFs):– ETFs permit investors to buy long or sell short certain baskets

of stocks.• Such as the basket of stocks that comprise an index like the S&P

500 or NASDAQ 100.

– This can provide investors with a more broadly diversified correlation (or inverse correlation) for market and industry or asset class risks.



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• Selling a Forward Contract of Futures Contract:– A forward contract is a contract negotiated privately or traded

over-the-counter to deliver a security at a specific time in the future, at a specific price.

• With the advent of single-stock listed futures contracts on an ever-increasing number of companies, investors can now sell standardized futures contracts on many companies.

• Futures and forward contracts will trigger the constructive sales rules.

– They are substantially identical property.



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• Offsetting Notional Principal Contract or Equity Swap:– An offsetting notional principal contract is one where the holder

of a security or bundle of securities agrees to pay substantially all of the investment yield and appreciation from the security or the bundle of securities for a specified period.

• Generally, in return, the investor receives interest based upon an interest rate index or a bond index.

• The investor generally is also reimbursed for substantially any loss of value in the security or bundle of securities.



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• Pre-paid Forward Sale:– A pre-paid forward sale is a risk management strategy suitable for

investors whose primary goal is to monetize a concentrated equity position without incurring an immediate tax liability.

• May be appropriate for investors who have legal restrictions or practical limitations on selling their stock.

– Investors may received an up front payment of 75% to 95% of the value of their stock rather than the traditional payment for the full contract amount at the time the contract matures.

• Generally, the investor making the forward sale has no obligations to the counterparty until the expiration of the transaction.

• The amount of the up-front payment may be affected by:– The term of the contract – Prevailing

interest rates– The level of upside potential – Other market

conditions



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• What these hedging techniques have in common is that the owner of the securities continues to hold the securities.– All, or most, risk of loss (and opportunity for gain) on the

securities is transferred from the owner to someone else.– The owner has effectively disposed of the securities, while

retaining nominal ownership.– They also have the unfortunate consequence of triggering the

constructive sales rules.



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Options, Futures, and Other Derivatives

• Derivatives are so named because they “derive” their value in reference to the value of some other security or property.– These instruments do not represent an ownership interest in

the security or property.– They provide investors with the right or obligation to buy or sell

securities or property or to receive payments based upon the performance of some underlying security or property some time in the future.



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Nature of the Derivatives Markets

• The derivative markets are “zero-sum” games or markets.– A zero-sum game is one in which the average gain and loss of

all participants in the game is zero.– Derivative securities do not represent any ownership interest

in anything.– For every long position, there is a corresponding short

position.– It is a negative-sum game due to commissions and transaction

costs.



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• The concept of risk asymmetry refers to different risk tolerances and capacities.– Explains why investors invest in a negative-sum market.– Investors with varying risk tolerance and capacity to bear risk

provide both liquidity and depth to the markets, making them more efficient at pricing or valuing the underlying assets and the cost of risk transfer.

– These markets are risk transfer mechanisms.



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• Options markets are also a zero-sum game.– Options contracts deal with the delivery of a specified amount

of some financial instrument, commodity, or other property at a specified price (called the strike or exercise price) on (or before, depending on the type of contract) some specified future date.

• The principal distinction is that options give one side of the position the right, but not the obligation, to buy or sell and the other side the obligation to sell or buy if the other side exercises his right.

• In futures markets, both sides of the transaction have the obligation to either buy or sell depending on whether they are “long” or “short” in the transaction.



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• Derivatives are highly leveraged instruments.– Investors have a great deal of flexibility.

• The markets are generally rather liquid and investors can take offsetting positions with just pennies on the dollar relative to the securities held long.

– The leverage is inherently risky.• Investors may lose all of their initial investment, or more,

depending on the type of hedge and the instruments they use.

• Misuse of these instruments for hedging purposes can lead to severe losses, far in excess of the original risk that was meant to be hedged.



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• The proliferation of derivative instruments stems from a desire to “span” the market and to provide vehicles capable of hedging many different types of risk in addition to potential losses in appreciated positions.



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Options, Spanning, and Synthetics

• A market or security is “spanned” if investors can combine derivatives in that market or on that security to reproduce the risk and return characteristics of the underlying market or security.– The creation of “synthetic” markets or securities– The benefit of spanning is that it makes markets more efficient,

since investors will exploit price differentials in the “synthetics” relative to the underlying market or security through arbitrage and force all the instruments into price conformity.

• If an investor buys a call option giving him the right to buy the stock, he is long in the call.



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• If an investor writes a call, collects the premium, and is obligated to sell the stock if the buyer exercises the option, he is short in the call.

• The long call position is equivalent to buying just the upside potential of the stock above the exercise price.– The short call position is equivalent to selling the upside

potential of the stock.



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• The profit profile of the long put position is equivalent to buying the upside gain potential of a short position in the underlying stock.– The short put position is equivalent to selling the upside gain of

a short position in the stock.

• Any combination of a long call and a short put at the same exercise price, even if different than the current market price, together with a corresponding investment in the risk-free asset to keep the total amount equivalent, will be technically equivalent to owning the stock outright.



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Option Premiums

• The option premium is the amount one pays for an option.– The intrinsic value of an option is the amount by which the

option’s strike price is in-the-money.• The intrinsic value of the option is the profit that could be realized if

the option was exercised immediately, and the underlying stock was sold at fair market value (disregarding the cost of the option).



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Option Premiums

• The option premium is the amount one pays for an option (cont’d).– The speculative value of the premium is a function of several

variables:• The volatility of the price of the security

• The length of the remaining term until the option expires

• The dividend payout rate and timing of payments

• The level of the risk-free rate appropriate to the remaining term until the option expires

• How far in- or out-of-the-money the strike price is



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Option Premiums

• Generally, there are two kinds of options available for most investors:– American options– European options

• The difference between the two is that American options can be exercised before the expiration date.– European options cannot



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Option Strategies

• Long Call:– The purchase of a naked call option is a bullish strategy employed

when an investor thinks the market will rise significantly in the relative short term (before expiration of the option).

– The downside risk is limited to the premium paid and generally no margin is required.

– Can be used to increase the effective portfolio weights in those asset classes that are underweighted until the investor can rebalance

• Short Call:– Shorting calls is appropriate if the investor’s strategic view is relative

certainty that the market will not rise and he is unsure or unconcerned about whether it will fall.

– The downside risk is unlimited.• In the money calls• Out the money calls



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Option Strategies

• Long Put:– For investors with a bearish perspective on market conditions for the

underlying asset and who expect the market value of the underlying asset to fall significantly over the term of the option.

– Maximum profit potential is the entire strike price of the stock less the premium paid.

– Maximum losses are limited to the premium paid

• Short Put:– Investors are virtually certain that the market will not go down, but thy

are unsure or unconcerned about whether it will rise. – The profit potential is limited to the premium received.– Potential loss is almost unlimited: the maximum loss is the strike price

of the contract minus the premium received



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Option Strategies

• Covered Call:– A long position in the stock combined with a short call

• Same profit profile and characteristics as a short put– Employed to increase income when investors expect the market price

of the underlying stock to fluctuate within a fairly narrow range over the term of the option

– The upside potential at expiration is limited to the strike price minus the market price of the stock

• Protective Put:– A long position in a stock combined with a long position in a put– Same profit profile and characteristics of a long call– The profit potential is unlimited.– The downside risk is limited to the premium paid for the put if the

stock position is entirely hedged by puts.



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Option Strategies

• Bull Spread:– A moderately bullish strategy investors may employ when they are

fairly certain that the market will not fall but want to cap the risk of loss.– Investors sell an offsetting position that also limits their upside

potential– Investors may implement the bull spread in two different ways:

• Bull Spread-Call– Investor buys an in-the-money call and sells an out-of-the-money call

with strike prices roughly equally spaced below and above the current market price of the stock

• Bull Spread-Put– Investor buys an out-of-the-money put and sells an in-the-money put

option with strike prices roughly equally spaced below and above the market price of the stock



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Option Strategies

• Bear Spread:– Investors may employ this strategy when they think the market will not

rise, but they want to limit their risk of loss.

– Investors sell an offsetting position that also limits their potential gain.

– Investors may implement the bear spread in two different ways:

• Bear Spread-Call– Investor sells an in-the-money call and buys an out-of-the-money call

with strike prices roughly equally spaced below and above the current market price of the stock

• Bear Spread-Put– Investor sells an out-of-the-money put and buys an in-the-money put

option with strike prices roughly equally spaced below and above the market price of the stock



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Option Strategies

• Collar:– A collar is a hedging strategy whereby an investor who wishes to

minimize potential loss in the value of a long equity position sells an out-of-the-money covered call option and uses the premium received to reduce or offset the cost of an out-of-the-money put option

• Limits the investor’s downside risk.• The downside protection comes at the expense of foregoing some

potential upside gains.• The maturity of a collar can range from several months to several

years.– Both options may or may not mature simultaneously.

• Investors who have legal restrictions or practical limitations on selling their stock may find collars useful.



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Option Strategies

• Straddle:– The investor thinks the market will be very volatile in the short-term or

a company is facing a situation that could greatly impact the stock price, either up or down.

– A long straddle position rewards investors if the price moves substantially up or down.

• Buying a call option and a put option with the same strike price– Unlimited upside potential

– A short straddle is for investors who think that the market will be less volatile.

• Selling a call and a put for the same strike price– Limited upside potential; downside is unlimited



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Option Strategies

• Strangle:– Used for the same purpose of a straddle

– Instead of buying or selling an at-the-money call and a put, the investor buys or sells an out-of-the-money call and put

• Reduces the premium cost for the long straddle as well as the maximum possible loss

– Loss is equal to the sum of the premiums on the long call and the long put

• Upside potential is unlimited• For the short strange, the lower premiums reduce the investor’s maximum

potential gain, which is equal to the sum of the premiums on the short call and the short put.



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Option Strategies

• Butterfly:– Another variation of the straddle which employs two additional out-of-

the-money options

– Long butterfly• Investors add an out-of-the-money short call and an out-of-the-money

short put to the at-the-money long call and at-the-money long put of the long straddle to reduce the net premium paid for the position

– Short butterfly• Investors add an out-of-the-money long call and an out-of-the-money long

put to the at-the-money short call and the at-the-money short put of the short straddle to limit downside rise



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Option Strategies

• Calendar Spreads:– Also known as time spreads– Consists of opposing positions in two options of the same type

that have the same exercise price but expire at different times



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What are the tax implications?

• Taxes are a key factor in evaluating how to most effectively minimize risk in taxable portfolios.

• For hedging strategies, two primary rules govern taxation:– The constructive sales rules

• Govern when investors initiating a hedge position have to treat the transaction as a sale of the hedged security even though no actual sale has taken place

– The straddle rules• Govern the tax aspects of closing a hedge position, including such

issues as tolling or freezing capital gain holding periods and capitalizing the carrying costs



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• Constructive Sales Rules– 1997 Tax Reform Act

• Provides that certain transactions attempting to neutralize future gain and/or loss in a current appreciated stock holding are treated as constructive sales

• Causes recognition of gain– A constructive sale is a transaction in which the owner of an

appreciated security enters into one of the following three transaction:

• A short sale of the same or substantially identical property• An offsetting notional principal contract with respect to the same or

substantially identical property• A futures or forward contract to deliver the same or substantially

identical property



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• Constructive Sales Rules (cont’d)– The term “substantially identical” is normally considered to be

securities issued by the same issuer, which are commercially identical in all major aspects including dividend provisions.

• Correlated pricing in the market is the key test for securities being considered substantially identical.– Meaning that the prices move virtually in lock-step



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• Initiating a put option purchase is not a constructive sale– An investor who purchases a put option should not have the

transaction treated as a constructive sale, even if the put option is for a stock the put holder already owns.

• Out-of-the-money put options only reduce some of the potential loss and none of the gain

• Must eliminate nearly all potential gain and loss to qualify

• A short sale on stocks or indexes not otherwise owned is not a constructive sale.– The shorted stock is not substantially identical to securities held long in

the investor’s portfolio.– Selling short a stock or stock index already owned is a constructive

sale.



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• Initiating a non-abusive collar should not be a constructive sale or taxable event– Creating collars that do not essentially freeze the value of the

stock within a relatively tight range should not trigger a constructive sale of the underlying stock

– Generally, collars are unlikely to be considered abusive if the term of the transaction is three years or less and the difference between the floor and ceiling price is at least 20%.



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Avoiding Constructive Sale Treatment

• Investors are required to ignore the constructive sale rules if they:– Close the offsetting position prior to January 30th of the

following tax year and– Retain their original position for at least 60 days after closing

the offsetting position

• They must go bare for that 60 days.– Without entering into another offsetting position for that 60-day

period.– If they enter into an offsetting position during that 60-day

period, the original constructive sale in the prior year is reinstated.



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Straddle Rules

• The straddle rules include most situations where a taxpayer is attempting to limit losses on an appreciated security by owning another security.– The Internal Revenue Code defines a straddle as “offsetting

positions with respect to personal property.”• A taxpayer holds offsetting positions “if there is a substantial

diminution of the taxpayer’s risk of loss from holding any position with respect to personal property by reason of his holding one or more other positions (whether or not the same kind.”

– Test of intent to substantially limit risk of loss– Straddle rules will apply to nearly any hedge that reduces the

investor’s potential for loss on an existing position within his portfolio



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Straddle Rules

• Straddle occurs when an investor owns stock and then enters in to an offsetting position such as:– An option on such stock or substantially identical stock– A position with respect to substantially similar or related property

• Property is substantially similar or related to stock when the fair market value of the offsetting position primarily reflects the performance of:– A single firm– The same industry– The same economic factors– Changes in the fair market value of the offsetting positions must

be reasonably expected to move inversely to the market value of the position held.



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Straddle Rules

• If an investor is in a straddle position:– The capital gain holding periods are suspended during the time

of the offsets– Investors may take no current deduction for losses to the

extent of any unrealized gain in the offsetting positions.• Losses on a straddle are deferred until unrealized gains on the

offsetting position are eliminated or realized.

– Investors must capitalize all carrying charges and interest expense during the offset period and add them to the basis of the long stock position.

• Reduces the amount of capital gain when the investor sells the long stock position.

• Straddle rules may convert LTCG to STCG’s



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Economics of Primary Hedging Strategies

• The basic question is whether the economics merit a hedging strategy considering:– All relevant taxes– The variety of potential price changes for the security or

portfolio to be hedged.

• Several possible outcomes should be modeled:– Using various rates of appreciation and potential depreciation– Considering taxation and other economics impacts such as:

• Lost opportunities for other investments• Dividend income• Transaction costs



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Where can I find out more about it?

• The American Stock Exchange• Chicago Board Options Exchange• International Securities Exchange• Pacific Exchange• Philadelphia Stock Exchange• The Options Clearing Corporation• The Options Industry Council



Investment Planning


Where can I find out more about it?

• High Net Worth Investors and Listed Options• www.ffstudies.org• www.twenty-first.com• www.occ.treas.gov/handbook/invmgt.pdf• www.occc.treas.gov/handbook/deriv.pdf

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