Daily Options Survey
The Weekly Option Strategist, August 4, 2011


A Suggested Hedge for Your Stock

This week, using calls on Intel Corporation (INTC) as examples, we show a suggested hedge for the underlying stock under current market conditions.  Our model, finds some Intel options to be underpriced, and some others to be overpriced.  You can get an edge by using these “mispricings” to your advantage when building a hedge.

A Look at Intel September Calls

In Graph 1 below, we show the implied volatility of the call bid and ask prices of September calls on Intel.  We also show our model’s strike price Adjusted Volatility Forecasts for these options.  These forecasts are take into account both basic underlying volatility and degree to which there have been unduly large moves outside the expected range of a normal distribution.

A Suggested Hedge for Your Stock 09-09-11 Figure 1

In this graph, we can see that the implied volatilities are highly skewed to the left with significantly higher implieds in the lower strike prices and lower ones in the higher strikes.  These higher implied volatilities are largely the result of hedgers’ buying nominally cheap put insurance to hedge their stock, which through arbitrage, gets translated into higher call premiums as well (see “A Primer on Put/Call Parity & How to Use It,” Ot080804.pdf, in Survey Issues).

Our own testing of past behavior on Intel (and on many other stocks) shows that these  lower strike puts and calls are often overpriced, with past action in the stock indicating a more saucer-shaped curve for our Adjusted Volatility Forecasts (see “Understanding Our Volatility Forecasts,” Ot100812.pdf).  In the case of the Intel September calls, the calls struck at $19.00 and below tend to be overpriced, while the ones above that level are underpriced.

Mispricing’s Your Friend

In Figure 2 below, we show an example using our Whatifi4.Xls position evaluator in which we have hedged 100 shares of Intel (INTC), priced at $21.65, by writing one September $19 Call at $2.83 and buying one steeply underpriced $24.00 call at $0.14.  Thus, we have hedged our stock with what is known as bear call spread (see “Consider the Bear Spread Hedge,” Ot110317.pdf).

A Suggested Hedge for Your Stock 09-09-11 Figure 2

This trade produces a net credit of $269 ($283 credit from writing the $19 call and $0.14 debit from buying the $24 call).  This is a wider credit than our model’s net estimate of $248, based on an estimated credit of $281 and estimated debit of $33. (These numbers are derived from using our Adjusted Volatility Forecasts and the relevant options data, such as stock, strike and time to expiration).

By adding the call buy to this hedge, we give ourselves some upside potential should Intel start to rally, increasing the current equivalent stock position or $Delta by $288 to $627.  (These $Deltas are derived by multiplying the delta for each option times the stock price times the number of underlying shares.

A Look at the Graph

In the Graph below the show the P/L of this hedged position on three different dates; the day the hedge was initiated (8/3/2011), half way to expiration (8/25/2011), and at expiration of the September calls (9/17/2011).  At expiration, as long as the stock ends up between the two strike prices, you end up with a small $4 profit on the net position. Below the $19 strike price, you will start to have losses, but these losses will be $269 less than they would have been had you not hedged.  If the stock falls 22% to $16.90, you will only lose $206 versus the $475 if you have lost had you not hedged at all.

A Suggested Hedge for Your Stock 09-09-11 Figure 3

Prepared by Lawrence D. Cavanagh, vloptions@valueline.com

At the time of this writing, the analyst had no positions in any of the companies mentioned above