Continuing my percentage hedge in Bank of America common and warrants, this morning I re-shorted the 450 shares of common I covered yesterday. This trade was executed at $16.51. So I’m back to long 5,000 BACWSA and short 1,750 BAC common stock.
I’ve also shorted 10 of the March 14, $16.50 call contracts at $.22. Here’s why.
The Wrong Way to Use Calls in the Hedge
Shorting calls as part of the hedge strategy is a great way to add extra income to the trade, as long as you understand a few points on being short calls against the warrants.
The single most important fact to know is that being short the calls is NOT a hedge in the same way being short the common is. Let’s look at our current hedge to show how this works.
Instead of long 5,000 BACWSA and short 1,750 BAC common, assume we’re still long the 5,000 BACWSA, but instead of BAC common we’re short 18 contracts of the March 14, $16.50 call here at $.22. Now let’s assume BAC common drops $2 to around $14.50.
The Class A Warrant will drop to around $6.80 (based on historical patterns), so we’ll lose $.45 on 5,000 or $2,250. The call will expire worthless in a little over a week-and-a-half, so best case scenario we’ll make $396 on our short call position for a total loss of $1,854.
But, with our actual position, we would have made $3,500 on our short common position, and still lost $2,250 on the warrant, giving us a profit of $1,250. A HUGE difference as we trade this hedge position over and over.
The Right Way to Use Calls in the Hedge
Now, assume we have our current position, long 5,000 BACWSA and short 1,750 BAC common. Looking at the stock where it is right now, at around $16.50, I’ll probably short another 1,000 if it gets to $16.70.
Instead of waiting for the stock to get to $16.70 I can short 10 contracts of the March 14, $16.50 strike call right now at $.22 (or the equivalent of $16.72). Then three things could happen over the next week-and-a-half.
- The stock could move down, in which case we’d have on our original long warrants / short common hedge, and we’d make money as laid out above. But we’d also get the additional $.22 from the calls.
- The stock could stay flat between now and next week, in which case we’d collect the $.22 call premium.
- Or, the stock could move up and we’d be short the additional 1,000 shares of common at $16.72, which is the plan as of now anyhow.
It may not seem like a lot, the extra $.22, but over time as I continue to trade this position that extra $.22 every few weeks, in a $16 stock, really adds up on a percentage basis.
Factors Behind the Trade
In my original post I said that I’d be talking about some of the criteria I like to have in place in order to do the percentage hedge. One of those criteria that adds a great deal to the trade is the availability of weekly options in the stock.
I went through why this is helpful above, and in some cases it can really mean the difference between doing the trade, and the opportunity not meeting my trading goals. Shorting those call options on a weekly basis can add a few percentage points each month to a stock / warrant combination that doesn’t move often enough on its own to merit placing your capital into the hedge.
Always be on the lookout for the weekly calls, and take advantage of them to add some cha-ching to your account.