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Author: TMFGebinr Big gold star, 5000 posts Top Recommended Fools Old School Fool Supernova Phoenix 1
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Subject: Re: Announcement of upcoming trade Date: 2/4/2014 12:10 AM
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Regarding my post elaborating more about why I was rolling NFLX covered calls (click the subject line of this post to see that, if you haven't seen it already), I was asked the following question. To share the answer with everyone, I'm posting and answering it here:

when You say I should have shorted 100 shares of NFLX and closed - what do you mean?. how do you do this? can you elaborate this for me?

When a put goes badly against you, the time value essentially disappears, especially for a deep in the money put. Thus, for every dollar the stock price falls below the strike price, the put seller loses a dollar.

However, that can be offset 1-for-1 by shorting the stock. There, for every dollar the stock drops below the point at which shares were sold short, the person in the short position gains a dollar.

So, if I had shorted 100 shares of Netflix as it passed $230 on the way down, every dollar I lost via the put (remember, I would eventually be put shares at $230 that were worth $115, a loss of $115), I could have regained by shorting at $230 (where I would gain $115 over the same price move). Then, when I was assigned the shares, I'd use them to cover the short position and I would have been out a net of $0 and owned 0 shares.

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.

Hope that clears it up.

Cheers,
Jim
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