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The QQQs have one dollar between the strikes, so the strike prices are not particularly wide. Also, in most cases, you can get a penny between spreads, and sometimes, maybe two cents. For some reason, this has a 3-cent spread today. We’re looking at the June 5. I want to look at the July spreads.
Here we go. Here are the July options. There is a one to two cent spread here, and here. There’s a one-cent spread in between these. They’re extremely liquid options. The open interest, you can see, is huge. Look at these 48s here. They have 200,000 contracts open. If we wanted to hedge our position, if we wanted to get our position Delta-neutral, what we would do is look at the QQQs.
You can also look at some other indexes. You could actually beta weight your stock position that you’re buying, against any of the indexes. Let’s say, for example, the S&P 50 ETF, or the SPY. You could do the exact same thing. I don’t like to use the SPY to hedge my portfolio, because they do have slightly wider bid-ask spreads. They have 10 cents on these, here. This is 5 cents.
Let’s make sure I’m looking at the July contracts. I am. Or you could use something like the DIAs, which is the Dow ETF. You could use that as well. They have a little bit better bid-ask spreads, about 4 cents, but why use those when the QQQs have the dollar wide strike prices, and the very tiny bid-ask spreads?
What I would do is go back to my Analyze tab. We’ve analyzed our stock. We’re buying 100 shares of PSYS. We have a portfolio beta-weighted position. Now, what we want to do is get our Deltas to a neutral position, to help protect our stock. We have unlimited upside potential, but we also have limited downside potential. The potential could go down to zero, if the stock goes down to zero.
We don’t like that kind of position. We’re going to put in the QQQs here, to beta-weight our portfolio. We’re going to go back to our Trade tab, and we’re going to select a $48 put, which is just about at the money. We’re going to bring that over to analyze, a QQQ 48 July put. We’re going to put it into our mix, and see what we come up with.
If we purchased one share of the QQQs, or one contract of the QQQs at the July 48 puts for $1.36 – on a portfolio-weighed basis, taking into consideration the stock that we have, it reduces our Delta down to 32, almost 33. That’s not bad. If we take that out, you can see that based on the QQQs – because we’re beta-weighting our stock position against the QQQs, here – we have a Delta of 77. If we purchased one of the 48 puts, it gives us a negative Delta, 44.96, against our 77 beta-weighted position. Now we have a Delta of 32.
If we purchase two of these, it almost brings us to a Delta-neutral position. It actually makes us a little bit short Delta. What you decide to pick depends on your comfort level. Our maximum risk, if we were to purchase two of the QQQ 48, puts us into a position where, if the stock doesn’t move at all, we’re going to lose about $267. This is acceptable, in these kinds of positions. If we selected one, to hedge against our 100 shares of the PSYS stock, then we have $149 of maximum risk in this position. It does hedge us very nicely, in any kind of downside action.
In fact, if the stock drops dramatically, we can actually make some money on this stock. Our maximum risk is right around $145, if the stock does not move at all. It also does not limit our upside potential. If the stock continues to move up, we have unlimited profits to the upside.
You don’t necessarily have to buy an option on the stock that you’re actually buying. Like I said, this PSYS stock looks kind of attractive, with this little flag pattern going on here. Eventually, this stock will probably continue its uptrend. The problem is, of course, is PSYS has very illiquid options. I just don’t like these options, because there’s very few outstanding contracts here. Getting in and out of these, if we have to, could be a bit of a problem. It’s going to cost us a lot more money.
Using the QQQs to hedge this position and give us a limited downside risk, and keeping intact our unlimited upside potential, is a better choice. We just selected one stock here. We could actually probably go through a couple of different ones. Even if the stock has option contracts on it, it doesn’t mean that we have to use the option contracts on that particular stock. We only use those particular options on those particular stocks if they’re highly liquid, and they have very small bid-ask spreads, like it did on Starbucks.
Let’s go over to another stock that we’re interested in buying. Let’s say that we’re interested in buying this Woodward Governor. It’s a stock that has fairly low daily volume, but it looks like it has a lot of potential. I’m just using this as a hypothetical example, of course. I’m not recommending this stock.
Let’s go ahead and purchase maybe 100 shares of that. Let’s say we wanted to buy something else, as well. We’re looking through our NASDAQ stocks in the news, and we see Flir Systems. We’re going to buy 100 shares of that.
We’ll go over here and take a look at our charts. It looks like an interesting stock. It’s been going up. It could be a very good trade. Let’s take a look at WGOV really quick. That’s been going up, and it looks like it has potential.
Now, you have maybe three stocks here, that you want to purchase 100 shares of, each. How do you protect all of these? Let’s analyze that as a duplicate trade. Let’s take the FLIR stock and analyze that as a duplicate trade. Now you have three of these, and what you have done is – you want to beta-weight this against the QQQs, here.
Our downside protection doesn’t look very good, because we only had one contract on the QQQs. Now we have 300 shares of stock, in 3 different stocks. How do we protect these? How do we do a covered stock position on these?
All we have to do is increase the number of puts that we’re purchasing. Remember, when we did our Starbucks stock, if we started out with 1000 shares, we had to buy 10 contracts on the puts in order to equal the same number of shares that we had on our stock. Each contract, remember, is equal to 100 shares. If we have 300 shares of stock, then it makes sense that if we increase the number of puts that we purchased, it will give us a simulated protection, just like we did on our covered stock position.
The only difference is that we’re using the QQQs as a hedge against our stock position. This is the way the hedge funds, the large investment managers, do it.