Page 330

Hedging works pretty much the same way in the financial world. You might have heard that many investors buy gold at the threat of inflation. Remember our discussions in Chapter One about inflation and how money is devalued. Gold, on the other hand, has historically risen in price to keep up with inflation no matter how severe the situation. So those investors buying gold, protect their assets in case inflation flares up. In other words, they hedge against inflation.

Getting back to our topic, options can also be used as hedging instruments against their underlying securities. How? Let's look an example. Suppose you own 200 shares of Ford at $50 in January 2000. Being a cautious person, you want to insure your 200 shares against losses for the month of January. Would you go to an insurance company to take out an insurance policy? Who knows? These days you can just about insure anything. The point is, most investors wouldn't think of an insurance company to protect themselves against losses in stocks. Instead they look to options. And in this case you may go ahead and purchase 2 FMJ (January 50 put) contracts to hedge against losses in your 200 Ford shares. At $2 premium those contracts would cost you $400, but they protect your 200 shares of Ford until their expiration sometime at the end of January.

And this is how they do it. If Ford is at or above $50 come expiration, those options would expire worthless and you lose the $400 plus commission. This is just like the homeowner's insurance - as long as your home is safe and sound you lose the money you pay towards the insurance premium. On the other hand, if Ford has declined to $40 at FMJ expiration, those contracts would now be $10 in the money and therefore have a $10 premium. In other words while your shares have lost $10 in value (from $50 to $40), your contracts are now worth $10 in premium for a net loss of $0. Pretty good huh? Had you not bought those contracts, you would be $10 per share in the hole. Now if you …