Friday, February 6, 2009

Breakeven on a hedged position

I am working a practice question that has confused me.
Question: An investor has purchased West German marks at 65 and has purchased a 65 put for .75. At what point would he have a profit?
65.76. Since the investor buys the marks at 65 and buys protection, a 65 put for .75, the breakeven is 65.75. The investor is losing below 65.75 and gaining above 65.75; therefore the only number greater thank 65.75 is 65.76.

I thought for puts you PUT DOWN for the breakeven, so how is it 65.75?

When an investor buys a put all buy itself, he is speculating. In that case you would, as you say, "put down for the breakeven." If I buy an XYZ Oct 50 put @3, the breakeven is 47. I need the stock to drop below that point to have a profit.
But, when I'm hedging with a put, it's only there for an emergency--I don't want to have to use it any more than I want to use my homeowner's insurance. Still, I pay my premium so that I have protection against disaster. Therefore, I have to add the premium I pay to the price I pay for the stock to find my breakeven. Similarly, a homeowner should add the premiums she paid for the homeowner's insurance to the price she paid for the house when trying to figure her profit upon selling the house.

When I buy 100 shares of XYZ for $55 and then buy an XYZ Oct 50 put @3 for protection, I'm hoping to never have to use that put. If I have to use it, that means my stock has dropped and I'm selling at a loss of $5 per share, plus the $3 premium. What I'm hoping is that XYZ stock keeps rising, and I just sort of forget about the put, glad I never had to use it. Since I paid $3 for the protection, I won't break even until XYZ rises to $58. And, I won't profit until it rises above $58.

Same thing in the question you cite above. Take the price paid for the currency. Add the price paid for the put. Then, make sure you know whether the question wants the breakeven, or the price at which the investor profits. Remember, those are never the same thing. Breakeven is a "tie." Above or below a breakeven an investor would have a profit.


  1. Please explain this question: A manager of a GNMA fund wires covered calls against the portfolio to enhance the funds's investment return. For tax purposes, distributions by the fund would be categorized as: A) ordinary income B)capital gains C)capital losses D) Capital gains and ordinary income. Answer is D because any interest distributed will be considered ordinary income, but any profits generated by trading the porfolio will be considered capital gains. The question didn't ask about trading it asked about distributions so why wouldn't the answer be A?! UHHHGGGHH

  2. I'm not in love with the explanation they provided. The explanation uses "trading the portfolio." If I had written the question, I would have linked the explanation back to "writing the covered calls." All that's going here is this--a GNMA fund would distribute the interest paid on GNMA pass-through's to investors. Covered call income = capital gains, as does most options trading activity.
    If you read a prospectus for a GNMA fund (which would not take more than 15 minutes total time to find, download, and read), I wonder what you'd find under "distributions" from the fund. I bet it's more complicated than this question implies. But each exam question is simply a set of four choices--pick the one that works the best. We can eliminate "capital losses," since funds don't distribute losses--they just go down in value/NAV. Your answer choice has to include the facts about GNMA and the covered calls. Only D includes the interest that GNMAs generate and the capital gains that covered calls generate. I bet most people would struggle with this question--thanks for posting it.