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THE VALUE LINE
Daily Options Survey
The Weekly Option Strategist, June 2, 2010

Building a Long/Long Hedge

With summer approaching and premiums apparently still reasonable (despite the June 1st selloff), we thought it a good idea to revisit our Long/Long Hedge.  Using our Screener (Old Version), we searched for 15 bullish call buys and 15 bearish put buys, all on options that are underpriced.  In this report, we have attached copies of our screening criteria, our display options, and a portfolio spreadsheet with all 30 positions. The total capital outlay of this diversified portfolio of options comes to a little more than $10,000.

Our Market-Neutral Hedges

Our market-neutral hedges are designed to take advantage of Value Line’s ability to differentiate between strong and weak stocks (through our common stock ranking system) and of our option model’s ability to pick favorably priced options.  The Long/Long Hedge buys rank 1 calls and rank 1 puts.

We calculate the performance of our Long/Long Hedge from the average gains and losses of all our rank 1 calls and puts (see Graph 1 below). Since there are thousands of different rank 1 calls and puts on any given day, it is virtually impossible to reproduce the exact results of the Hedge as shown in the performance numbers that we collect.  However, we believe that a diversified portfolio of at least 20 rank 1 call and rank 1 put positions (approximately 10 on each side) can produce substantial gains, especially when there are broad swings in the market.

Screening For Puts and Calls

In Figure 1 below, we show a sample screen that we have used to find calls that might be useful for such a hedge.  We have specified that we want rank 1 calls based on rank 1 or rank 2 stocks. 

07_18_11 Weekly Options Strategy - Figure 1

 

To create a similar search for puts, simply change the Ranks tags to Naked Put Buyer’s rank of 1 and Common (Stock) rank of 5 and 4 stock.

Building a Hedge

In Figure 2 below, we have constructed such a sample hedge, choosing 10 rank 1 calls and 10 rank 1 puts that are reasonably close-to-the-money and that expire in August 2010 or later. The positions range in value from $288 to $630.  As constructed, the Hedge has spent a total of $9,361 in premium, $4.376 for calls and $5,256 for puts.  Because of the spreads between the bid and ask prices, the entire portfolio shows a start-up loss of $478.

Trying this at Home

In our web version of this report, we have attached two screens (CallBuyHedge.Txt and PutBuyHedge.Txt) that can be used to search for likely hedge candidates.  We have also included a save display format (HedgeDisplay.Txt) that can be used to show the screened options. Notice that for convenience sake, this display shows only one option per underlying stock.   We have also attached an Excel version of the Portfolio, LongLongHedge.Xls. Copies of these files are also available by emailing us at vloptions@valueline.com.

Graph 1 - Long/Long Hedge versus the S&P 500

07_18_11 Weekly Options Strategist - Graph 1

 

Figure 1 - Sample Screen for Calls

07_18_11 Weekly Options Strategy - Figure 1

Figure 2 - Sample Long/Long Hedge – Trade Date 7/20/2010

07_18_11 Weekly Options Strategy - Figure 2