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Contract Neutral Hedging

How Does Contract Neutral Hedging Work in Options Trading?

Contract Neutral Hedging - Definition

An option trading hedging technique which covers a stock holding on a share by share basis with stock options.

Contract Neutral Hedging - Introduction

Unlike Delta Neutral Hedging, Contract Neutral Hedging is a static hedging technique suitable for amateur investors hedging long term stock positions and are willing to pay a slight premium for doing so. Contract Neutral Hedging is simply buying 1 contract of put option or writing 1 contract of call option for every 100 shares held and is extremely suitable for amateur retail investors as Contract Neutral Hedging do not require complex calculations nor does it require a daily or even hourly rebalancing of the hedge like what is required in a Delta Neutral hedge. Protective Put and Married Put are Contract Neutral option trading strategies.

Contract Neutral Hedging Example:

Assuming you own 200 XYZ shares at $50. $50 strike price Call Options and Put Options trading at $3.00 each.

To protect against a drop in value of the XYZ shares below $50, you decided to execute Contract Neutral Hedging by buying to open 2 contracts of XYZ's $50 strike price put options for a total price of $600. 2 contracts of put options represents 200 shares of the underlying stock, making a Contract Neutral Hedge.

Assuming XYZ shares drops to $40 upon expiration of the $50 put options

Loss on XYZ Shares : $10 x 200 = $2000

Gain on $50 Strike Put Options : ($10 x 200) - $600 = $1400

Loss on XYZ shares are totally hedged with $600 as the price of "insurance".

Contract Neutral Hedging - Requirement

Contract Neutral Hedging can only be achieved through the use of stock options as it requires an instrument that will rise in value in step with a drop in the underlying stock while not losing money if the underlying stock rises. Stock options are the only financial instruments which offers such unlimited profit potential but a maximum loss limited to the price paid for it, which is only a small fraction of the price of the stock. This makes options trading very powerful.

Contract Neutral Hedging - How

Unlike Delta Neutral Hedging with all its complex delta calculations, Contract Neutral Hedging only requires buying or writing the same number of stock options as the number of shares held, bearing in mind that 1 contract of stock option represents 100 shares. So, if you own 300 shares, you would buy 3 contracts of put options in order to achieve Contract Neutral Hedging.

Contract Neutral Hedging - Popular Options Trading Strategies

Here are some popular options trading strategies utilizing the concept of Contract Neutral Hedging:

Protective Put - The buying of as many put options as the number of shares held in order to seal in existing profits.

Married Put - The buying of as many put options as the number of shares held right from the onset in order to hedge the position from going into a loss.

Covered Call - The selling of as many call options as the number of shares held in order to decrease downside loss and increase upside profits.

Covered Call Collar - The buying of put options in addition to a Covered Call in order to eliminate downside loss while still increasing upside profit.

Contract Neutral Hedging - Relation To Synthetic Positions

Whenever a Contract Neutral Hedging position is established, a corresponding synthetic position also becomes created. A complete understanding of synthetic positions is necessary to prevent unknowing creating unfavorable positions.

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