· Using an upside short call to purchase a downside put spread

Hudson Chatham

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This is not a trade recommendation, this paper is for educational purposes only, to describe a possible hedge and subsequent trade for an investor holding a profitable position, who does not want to be subject to tax consequences by closing the investment. We are using NVDA in this case study because it is a popular investment, and many have profits to protect.

In this scenario, the investor would sell an upside call, perhaps 10-20% higher and purchase a downside put spread with the proceeds of the call price. The put spread should be in the money if the investment trades 10–20% lower. The strategy we are discussing is to get paid for placing this hedge and to get paid on the downside to close the hedge. To achieve this, we would want to look for a spread where the upside call is priced higher than the cost for the downside put spread, creating a credit when all three options are netted out. We should note here, this is not a perfect hedge — it is designed to limit losses as well as allow some upside participation. The hedge described will not protect the underlying 100 delta stock holding dollar for dollar. This hedge would be placed as a credit so in the event of the investment closing lower than the upside call, the investor earns the credit.

When I first started to write this article on July 10, 2024, I didn’t anticipate NVDA selling off as quick as we have seen. I’m the first to admit I’m not an equity guru, though experience told me NVDA might be slightly overextended after the recent stock split or possibly the hype about AI was a little over exuberant. Whatever the case, NVDA was trading 134 the day I set the initial prices. I’m offering the prices as a look back, demonstrating how to handle the position, as the investment falls in price, by closing the trade.

On July 10th, with NVDA trading around 134, the Dec 19, 2024 expiry 145 calls were trading 15.55 bid, the Dec 19, 2024 expiry 125 puts were 12.20 offer and the Dec 19, 2024 expiry 115 puts were 8.10 bid. My proposal was to sell the Dec 145 calls — allowing 10% upside — and buy the 125 / 115 put spread (paying $4.10 for the put spread, 12.20–8.10 = 4.10, selling the 145 calls at 15.55; 15.55–4.10 = 11.45 credit) to offer partial protection down 10 to 15%. With the prices mentioned, the net credit on the position is $1145 per spread on 100 NVDA shares. This means you are paid the $1145 to add the position to your portfolio for each spread on 100 shares. These prices are slightly unusual due to the past upside bullishness of NVDA skewing the call volatility of the upside curve.

The evening of September 9, 2024, with NVDA closing around 107, the closing price for the Dec 19, 2024, 145 call is 2.70, the Dec 19, 2024 125 put is 23.50 and the Dec 19, 2024 115 put is 17.30. If the investor were to decide at this point, they are bullish on NVDA and want to cover the hedge, the position can be closed now for another credit (125–115 put spread: 23.50–17.30 = 6.20), minus buying back the 145 calls at 2.70 is (6.20–2.70 = 3.50) will result in a $350 credit per 100 shares. The total payment to the investor is $1495 ($350 + $1145). The NVDA stock is lower by 27 points (134–107) or $2700 per 100 shares. The loss here at 107 using the hedge nets out to minus $1205 per 100 shares. The investor saved him/herself the $1495 out of the possible $2700 loss by adding the hedge and closing the position.

In the case you hold the hedge until December 19, 2024, on expiry, if NVDA stayed below 145 and higher than 125, the investor with this hedge would earn the $1145.00 credit. The theoretical breakeven on the upside is the 145 strike plus the $11.45 credit (145 + 11.45 = 156.45) which would offer the investor upside participation to the 155 area. The maximum downside protection ends just above 105 (115–10 = 105, allowing the 145 calls to be worthless), with the 125–115 put spread worth close to $10.00 or $1000 credit when sold. Note — you will not be able to sell the 10-dollar put spread at $10, possibly 9.95 on expiration day if the market makers can buy stock at 105. From 134 to 105, the 100-delta long NVDA investor would have lost 29 points or $2900 per 100 shares. The hedger in this case study will have minimized the loss to approximately $760 at 105 on expiry or $560 at 107 (1145 credit plus the $995 closing of the put spread = $2140: $2900 — $2140 = $760).

To summarize, there are spreads available to help clients minimize capital risk at inflection points in the market. Knowing the risk you want to hedge is the first step to designing a strategy for protection.