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Hedging Risk in 2009 has really become the mantra of many traders. After a tumultuous 2 years in terms of statistical market movement, anything that can be done to reduce day-to-day run ups and draw downs is considered a win by any money managers' standards. But did you know there are many more ways to hedge risk than simply with options? I would like to run down a few such "hedges," if you will, with examples to boot.

Calendar Spreading, or "time spreading," involves the use of options, trading one month and offsetting the position with a different month across the same underlying. These are also called horizontal spreads, time spreads, and even intra-market spreads to our futures and commodities friends.

Chart 1

The most typical are selling front month options and offsetting the position buying longer term options for a spread premium, with the expectation that the spread premium will widen over time. Assume XYZ is at 150 and you expect it to stay where it is. Selling the January 150 put and buying the February 150 put is an example of a long calendar spread, meaning you are long the back month. Some traders who expect the contracts to contract over time will do the opposite, buying the front month and offsetting the position by selling the back month option.

Traders do one of the following with these types of calendar spreads: they will either trade the back-to-back options contracts, buying one contract and simultaneously selling another (January and February, for instance), or will trade multi-month options (January and April, for instance). Either way, this hedge is to offset outright risk that an option position might have by itself.

Hedging Stock with Stock Futures - One way this could be done with the underlying stock would be to offset a long stock position by selling single stock futures contracts. Those of you who understand collar spreads might want to take a look at this position when looking for the best return on risk. Here's how it works:

Let's assume you own 100 shares of XYZ and you want some short-term protection in the event of a price decrease. You can sell the January XYZ stock futures contract (1 contract = 100 shares of short stock). Here are the details of SSFs:

• Contract size - 100 underlying shares
• Settlement style - physical delivery of underlying shares
• Quotation - U.S. dollars per share
• Minimum tick increment - $0.01 per share = $1.00 per contract
• Trading halts - coordinated with the applicable securities exchange
• Last trading day - third Friday of delivery month

You might wonder what goes into the premium of a Single Stock Future. Well, not much different than an option - the underlying stock price, current interest rates, future dividends, and days until the contract expires. Strike prices are not part of the equation since this is a moving instrument.

Margin is currently 20% of the contract price, and there are murmurs of basing these contracts to the ever popular portfolio-based margining. Until then, margins are fairly attractive and offer the trader one more way to hedge a stock portfolio in a spreading type scenario.

Next week we will discuss a few NON-OPTION type spreads in the industry and how you can take advantage of them.

Good Trading,

Tom Gentile
Chief Strategist
Profit Strategies Group, Inc.

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