No, this is not that green growing fence in front of your house that needs trimming every year. Instead, a hedge is a method of reducing risk by putting on one option position and simultaneously selling another that contradicts what you hoped would happen with the first option. Sounds like something a schizophrenic might do. But it does make sense even to a rational investor.
With a hedged bet, you give up some possible gain in exchange for a reduced loss if the market does not behave as you expected it to do. A good example of a hedge is any option spread you might buy. Common examples are the calendar spread, a butterfly spread, or a vertical spread.
In the option’s world, intrinsic value is the difference between the current selling price of the underlying stock and the strike price of the option. If an underlying stock is trading at $45 and a call option with a strike price of 40 is trading at $6, the intrinsic value of the option is $5. The other $1 is called the time premium of the option. It is the extra amount you have to spend to enjoy the benefit of having the right to buy the stock at $40 without having to come up with all the cash.
This is something your broker will charge when you sell a credit spread with options. There is no interest charged on a maintenance requirement but cash in your account is set aside by the broker. You can’t use this cash to buy other options or stock.
The requirement is calculated by the maximum amount that you could theoretically lose on the spread you place. For some silly reason, the broker wants to make sure that you end up with enough cash to cover that potential loss so that he doesn’t have to cough up the money himself. It doesn’t really sound fair, does it? With all the commissions the broker is collecting on your trades, you would think he would be willing to take a little risk once in a while. But that’s not the way it works. They insist that you take the entire risk.
One neat thing about selling a credit spread is that the cash you collect from selling a credit spread is used by the broker to offset any margin loan you might have on stock that you have purchased. So if you break even on the credit spread, you might save a little in interest on your stock margin loan. It probably won’t change your way of living, but it beats a stick in the eye (as my mother used to tell me whenever I complained about something that was a positive, but only slightly so).
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