Using call options as a hedge

As can be seen in the following chart, the share price of ONEX Corporation (ONEX) has been weak enough to suggest that some caution may be necessary. The Relative Strength Index (RSI), which was recently in oversold territory, is trending downward. The same is true of the stochastic oscillator (%K).

Although the scope of the decline remains to be determined, an investor interested in acquiring some protection while taking advantage of the erosion of the time value of options could write a call option for each 100 shares held. With ONEX trading at $91.15 at the time of this writing, we will select call options expiring on September 21, 2018 with a strike of $92.

Position

• 1,000 shares of ONEX are already held (current market price: $91.15)

• Write 10 call options ONEX 180921 C 92 at $3.50
  • Credit of $3,500

Profit and loss profile

This out-of-the-money call option has no intrinsic value and a time value of $3.50 per share. Writing this call option provides protection against a 3.84% drop to the breakeven price of $87.65 ($91.15 – $3.50). In the event that the share price goes up, closing at or above the $92 strike on expiry of the options on September 21, the strategy’s maximum profit will be $4.35 per share, or 4.96% for the 130-day period (13.93% on an annualized basis). If the stock price is unchanged, the static return would be $3.50 per share, or 3.99% for the 130-day period (11.21% on an annualized basis).

Intervention

Since we expect the share price to fall but have no specific target for it, we will close the position if we can buy back the call options written at 10% to 20% of their initial price. Should this occur, we will need to analyze whether the right approach is to hedge the position again by writing more call options. Should the share price rise above the $92 exercise price, we need to buy back the call options at a profit or a loss, as the case may be, to avoid having them assigned and having to sell the underlying shares.

Good luck with your trading, and have a good week!

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.