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Real-Money Stock Picks / Messed-Up Expectations Portfolio


Subject:  Re: Announcement of upcoming trade Date:  2/4/2014  12:11 PM
Author:  BrianMotleyFool Number:  1021 of 1287

>> That's why the correct hedge for a put going badly against the seller of the put is to short the stock as it crosses the strike price on the way down. Of course, one cannot know ahead of time that this will be needed, so maybe the short wouldn't be opened until $200 (using this example), so $30 of the $115 loss would have been realized, but still better than taking the full $115 loss as I did.<<

Just a word of warning - be very careful with this hedging strategy.

It works well if the stock continues moving downward in price, but exposes you to all sorts of pain if the stock reverses. In this case, you would be exposed to a loss from the short sale for all the upside, while the put you sold will only earn you the premium.

You can, of course, cover the short position as the price heads back upward, but you risk being eaten up by transaction costs if the price bounces around the option strike price a while. Alternatively, you can buy some calls to hedge the short sale. This is the safest option to limit potential losses from the short common, but of course if the stock price continues to fall as you expected when you made the short sale in the first place, then you have locked in the loss of the call premium.

If only you could know the future, this would all be much easier...

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