Derivatives

You can design your investment with predictable outcome!

In certain situations you might need your investment to behave in a specific way. For example you might require positive investment return to fall within a certain range. Using strategy called Option Hedge you can achieve this goal. Option Hedge is a position where the investor sells (takes short position) more than one risk-offsetting options against each corresponding underlying unit. The effect is to maximize the profit when the underlying asset sells at the strike price at option expiration time. The investor gains when underlying asset price falls within range between break-even points and loses money when underlying price rises or falls beyond break-even point. Let's consider example when you own XYZ stock priced at $41. To build Option Hedge position you can sell (write) two Call options on XYZ stock for $4 with strike price $40. If at expiration time the stock price falls within range of break-even points $33 and $47, and let's say, equals to $39, then your profit is (Call options are out-of-the-money when stock price is $39 and you don't have to sell two stocks)

-$41 + 2*$4 + $39 = $6

Let's consider case when at expiration time stock price is out of the range of break-even points and let's say it rises to $56. Then Call options you wrote are in-the-money and you have to sell them for strike $40. But you own just one stock and you have to buy another one in the market (-$56). After you deliver these stocks (2*40) your loss is

-$41 + 2*$4 + 2*$40 - $56 = -$9

These cases in Investor are shown below

As you see you can design your investment in a way that will make the return to fall in a certain adjustable range, or in other words, make the investment return predictable.

Opposite to Option Hedge strategy is called Reverse Option Hedge. The purpose of using this investment position is to get positive return when underlying asset price moves away from the strike price, or in other words, when price is outside the range that is between break-even points. Within range of break-even points, or close to strike price, you lose money. Let's consider example when you borrow XYZ stock (take a short position in XYZ stock) priced at $42 and sell it in the market. You also buy two Call options (Long Call) on XYZ stock for $2 each with strike $42. If at expiration time the stock price is outside the region between break-even points $38 and $46, and let's say equals to $47, you exercise two Call options (-2*42), return back one stock you owe and after selling another stock in the market ($47) your profit is

$42 - 2*$2 - 2*$42 + $47 = $1

If stock price is within range between two break-even points and let's say equals to $44 then your loss is

$42 - 2*$2 - 2*$42 + $44 = -$2

These cases in Investor are shown below

Besides Option Hedge and Reverse Option hedge there are other derivative trading strategies that can be used to design investments with certain predictable outcomes. Spreads and Combinations involve several options and allow to design required profit patterns. In Investor you can find them under Trade tab.