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Applied options strategies: Hedging RIMM

The purpose of this article is to demonstrate how it is that an investor can use options contracts in a practical investment scenario. This will be accomplished by looking at the real-world figures surrounding an investment in Research In Motion (RIMM), and a specific position that could be implemented to create exposure to the stock’s volatility. While this position will demonstrate a material opportunity for returns, please remember that this isn’t a recommendation, it’s an evaluation of the scenario meant to demonstrate how it is that options are used in real life, with the intention of educating.

RIMM has been a particularly volatile stock over the last year, which makes it a ripe candidate for analysis. For the sake of contexts, we can look at the stock’s price chart over the last year to see the roller coaster that this stock has been lately.

RIMM

This level of volatility is again upon the stock, as it has more than tripled since its low point in mid 2012. Today, the options chain of this equity is equally demonstrative of the unpredictability, as investors try to protect themselves from the risks of the positions, and to take advantage of the massive fluctuations. Below is an image representing this volatility from a proprietary options platform I use for evaluating these kinds of situations.

It shows us how much of a premium is placed on call options by comparing the value of a call and its premium against the actual price of the equity. A spread of 0% therefore represents an option that is fully priced at the same value as the actual equity (0% arbitrage price), and then the ‘delta’ line shows the rate of change over different strike prices.

RIMM-2

This chart shows us two traits associated with the June-2013 options chain surrounding this investment (at least at the time of writing this article). Firstly, we can see that investors are pricing in a ‘perfect’ option at a strike price of approximately $5-7, suggesting that this is either the most liquid, or underpriced option chain on the market. When we dig in further, we can actually start to see an opportunity here. This is because of the way in which a $6 call option can be sold short with a premium of $9.85, giving it a full price of $15.85, as compared to the market price of the actual stock of $15.84. Because of how closely priced the intrinsic value of these securities are, we can build up a hedged position with a potential upside and limited downside.

The position to create using this information involves short selling a Call contract for $9.9, and then simultaneously buying 100 shares of RIMM for $15.84. The end result is that any increases in the stock price will not create a loss on the short sale, but will very quickly cause the position to get ‘called out’ by the purchasing party. In the event that the contract is called out, the 100 shares of the stock are assigned to the contract holder, and the end result is that the position has earned $6 based on the price discrepancy between the options contract and the share price.

That being said, we will have likely incurred about $15 worth of costs from our broker to engage this transaction, so the position will have really lost $9 in total. However, if the position decreases in value, the contract will be less likely to be called out. Additionally, the options position will essentially become less valuable, meaning that the position earns a profit. Assuming the position is not called out at all, the maximum profit that the position can earn is $985. That being said, should the price of RIMM decrease below $5.95, the position will start losing money.

In looking at how it is that this position interacts with RIMM’s recent volatility, there is a 60% upside on the position if the stock doesn’t move, and a 1% downside if the position gets called out. This creates a neutral position on the security, which suggests that the stock is either overbought in the short term rally, or that perhaps it is not going to jump again in the near term.

Regardless, the position is highly protected, given the nature of an investment in this security. That being said, RIMM has been a fairly dramatic story this year. Feel free to comment below, we’d love to hear about your opinions about what kinds of strategies you can come up with that would demonstrate the use of options to take on reasonable amounts of exposure to RIMM.

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