Subject: DITM calls and hedging
PROPOSED STRATEGY:

Buy very DITM LEAPS calls, say 50% DITM, on BRK or some other well-traded and well-chosen underlying (this has been discussed a lot on this board).
The DITM call's value will rise/fall nearly dollar for dollar with the stock price, so there's nearly 2x leverage for a 50% DITM call.
But leverage is not the point of the strategy below -- put protection is the point. We outline how to use some of the 'savings' from controlling shares with the call, as opposed to buying shares outright, to buy puts as a hedge.

"Leave the gun, take the cannoli."



STRATEGY DETAILS (real world numbers for BRK are shown in next post):

- Buy long dated very DITM calls, say 50% DITM, instead of BRK or some other stock. I'm not saying that *today* is a good time to buy BRK (or any other stock), am just outlining the strategy.
- You've "saved" nearly 50% of the stock price by buying the call
- What can you do with this near 50% savings?
- Many things: you can stash it in t-bills to be ready to snatch up stocks during a downturn, you can buy other investments to diversify,
OR:
- You can use some of the savings to buy ATM puts on the underlying to hedge. A worked example using real world numbers from this morning for BRK is in the following post.
- Buy long dated ATM puts, but roll them frequently for three reasons:
(1) To minimize time decay: if roll ATM puts about 1/3 way into the put's lifetime then it might lose about 20% value due to time decay (exact numbers depends on details, but generally you don't lose too much to time decay at 1/3 of the way into an option's lifetime)
(2) The investing thesis is that the stock will rise. If it rises, then the stock price can 'run away' from the put strike. But rolling the puts early addresses this. Rolling early also addresses time decay. so roll the long dated puts early.
(3) Typically, buying longer dated puts costs less *per day* than buying shorter dates puts. This is folklore and not a law (I've seen periods when it isn't true), so check both long dated and short dated puts at the time you plan to buy.
- The strategy doesn't have to use ATM puts, I picked ATM as the extreme case for a hedge (see real world numbers in next post). There's plenty of 'savings' left over even after buying ATM puts to hedge.
- "You need to buy 2x as many puts as the number of notional shares in order to hedge, because you have nearly 2x leverage in the 50% DITM call."
Not so: if you buy an ATM put and the price falls, then the intrinsic value of the put will rise dollar for dollar with the stock price fall. This offsets the dollar for dollar change in the value of the DITM call. Also, vol typically rises in a price fall, which further increases the put's value.

Pros:
- "You control the underlying with excellent put protection", ted thedog said hopefully.
Btw, you've still got leverage i.e significant 'savings' too, see next post for worked numbers.
So you're both hedged and have significant leverage or extra cash.


Cons:
- You give up any dividends (there aren't any on BRK, but other stocks or funds can have dividends. But it's not like dividends are 'free money' that you're missing out on, they deplete the coffers of the company.)
- If the stock price drops at the time you're ready to roll the puts and vol spikes, then the new puts will be expensive due to the vol increase.
But by the same token, the puts that you're holding/selling will also get more expensive (to the buyer) because you're rolling them considerably before time decay really hits, and they'll also be ITM, and vol will typically have risen, therefore, there'll be some offset of costs.
- Transaction costs enter due to somehwat frequent rolling of puts. But this shouldn't be much on a relative basis.
- It's not very tax efficient as outlined. Which may or may not be an issue, but a lot of U.S. people can do it in an IRA where it's a zero issue.
- It's more work. But you get canolli.

What's the catch?