...there are 6 basic positions
Each position can be described by the payoff at a variety of
prices of the underlying security. For example, if you buy a share
of stock, your profit is Purchase Price minus Selling Price. If you
buy a call options, your profit is Stock Price at expiration
minus Call Price minus Excercise Price. Caveat: If Stock Price at
expiration is less than the excercise price, then the holder elects
not to excercise the option and the profit is just -Call Price.
- Buy a share (a.k.a. go long)
- Sell a share short.
- Buy a call.
- Buy a put.
- Write a call.
- Write a put.
...what is a hedged position?
Consider the profit situation when you own (or go long) 1 share.
The potential loss is fairly large - equal to the amount paid for
the share. Of course the potential gain is infinite. But suppose
your knowledge of the firm or its markets convinces you that it's
precariously poised. The next few days could an incredible
announcement - probably something disasterous, although the test
results might possibly confirm that the firm's earlier rosy predictions.
In either case, you know something is up and you have suspicions.
Now if you add to your existing portfolio of 1 share, a put option - the
right to sell 1 share at a pre-specified (or Strike)
price, you have a hedge portfolio.
If the firm goes bust your share is worthless but you get back an amount
equal to the strike price. So your loss is limited. If the fantastic
happens and the firm becomes the next darling of Wall Street your payoff
is less by whatever you paid for the put, but still infinite. You're
...visualizing hedged portfolios
This visualization lets you invest in 3 securities of any of the 6 basic
types. The surfaces use a red-green colormap with green showing the
most likely outcomes (where likely is computed using a specified
average and standard deviation assuming a log normal distribution of
price fluctuations). Then you can view the overall behavior of your
selected portfolio. This signature is shown semi-transparently
in white if you select Securities + Signature in the Common
When you select Signature only or Signature colored by N(x)
the visualization shows the zero payoff plane with a semi-transparent
black surface. Portions of the signature above this plane make the investor
happy, portions below make her sad.
...what are some common hedges?
- Top Straddle... Write 1 call and 1 put. The signature will
show a right-side-up tent with (the big end pointing down).
- Top Vertical Combination... Write 1 call and 1 put.
By varying the strike prices you can change the bluntness and
width of the top of the signature so that you profit over a wider
range of outcomes than with a Top Straddle.
- Bottom Straddle... Buy 1 call and 1 put. The signature
will resemble and upside-down tent. The interpretation of this
is that the investor has no idea what will happen except that
she's sure any price change will be very big. She's betting that
the situation at expiration will be very different from the situation
- Bottom Vertical Combination... Buy 1 call and 1 put and
vary the strike prices to modify the
- Bullish Vertical Spread... Buy 1 call with a low strike
price and 1 put with a high strike price.
- Bearish Vertical Spread... Buy 1 call with a high strike
price and 1 put with a low strike price.
- Butterfly Spread... Buy 2 calls - 1 with a very low strike
price and 1 with a very high strike price - and 1 put with a moderate
strike price. The investor is betting against any major changes in
the market value of the firm's stock.