Selling Hedge

  

Categories: Derivatives

You own a large warehouse full of pork bellies. You plan to sell them in the near future for a sweet price. But...you start to get worried. There's word that scientists at CalTech have started growing synthetic pork bellies in a lab. They might perfect the process in the near future, and the bottom will drop out of the market.

You need a way to protect yourself against declining prices. Time for a selling hedge.

This process involves selling futures contracts (or options contracts) in order to hedge against a potential drop in the price of an underlying security or commodity (like your pork bellies). The goal is to provide a safety net...to protect yourself against the downside.

Related or Semi-related Video

Finance: What Is a Put Option?83 Views

00:00

finance a la shmoop what is a put option? hot potato hot potato

00:07

ow ow! yeah remember that game well nobody wanted the potato, poor thing. the

00:11

players wanted to put it in someone else's hands. well put options kind [glue put around a flaming potato]

00:18

of work the same way. a put option is the right or option or choice to sell a

00:24

stock or a bond at a given price to someone by a certain end date.

00:29

all right example time. you bought netflix stock at the IPO a zillion years

00:37

ago at $1 a share. that's you know splits adjusted. all right now it's a hundred

00:42

bucks a share. if you sell it you pay taxes on a gain of 99 dollars a share. in

00:49

California that would be a tax of something like almost 40 bucks. well the

00:53

stock was a hundred but you keep only something like 60. feels totally unfair.

00:58

right so you really don't want to sell your stock but you're nervous about the [graph shown]

01:04

next few months that Netflix will crater for a while and go down ten

01:07

maybe twenty dollars. longer term though you think it'll hit 300. so this is the

01:13

perfect setup to maybe look at buying some put options on Netflix. if the stock

01:18

goes down your put options go up. with Netflix volatile but at a hundred bucks

01:23

a share ,you look up the price of an $80 strike price put option expiring in

01:28

December, and you know that's mid-september now .for five bucks a share

01:33

you can protect your stock for the next few months .think about it like temporary [stocks placed in vault]

01:37

term life insurance. you pay the five dollars a share in the stock goes down

01:41

to 82 by mid December, worst of all worlds. well not only did you lose the $5

01:48

a share but your stock has lost $18 in value. but had Netflix really cratered

01:55

and gone to say $60 a share well you would have exercised your put and sold

02:01

your shares at 80 bucks. well those put options you paid $5 for

02:06

would be been worth 15 bucks a share. in buying that put option you've [equation shown]

02:11

guaranteed that your loss will be no more than a $75 value for your Netflix

02:16

position at least for that time period and ignoring taxes. well remember that

02:21

options expire after December whatever like the third Friday of the month it's

02:26

usually when options expire, you then have no protection and your shares float

02:31

along naked. naked? really who knew accounting could get so [paper put option goes "skinny dipping".]

02:36

raunchy. yeah well that's naked put options.

02:40

that's what they really are people.

Up Next

Finance: What is a Derivative?
23 Views

A derivative of a security is a "something" which derives its value based on the performance of that security... either a put option or a call option.

Finance: What Is a Call Option?
25 Views

What is a call option? A call option is a type of contract that lets the investor buy shares of a stock at a certain price and within a window of t...

Find other enlightening terms in Shmoop Finance Genius Bar(f)