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Hedges

A hedge strategy is the simultaneous purchase of an asset and an option on it. An example of this is the protective put, described here. One advantage of the hedge is that the holder is theoretically protected from downside risk. Continuing the protective put example, say we buy 100 shares of some stock at $50 and simultaneously buy one contract with strike price $50 that expires in six months. In this scenario, we are protected from stock price declines for the next six months.

No matter how far the stock price falls, we can always sell our shares for $50 a share. This is nice, except that transaction costs make this situation a losing trade: we pay commissions to get in and to get out, so at a minimum we have lost twice the cost of commissions.

Another significant disadvantage to a hedge is that it is expensive. Not only does one have to buy the stock, but also the option on it. For this reason alone, hedges are not good strategies for use in conjunction with the Darvas box theory system (mainly because I am poor and don’t want to fork over the money to buy the underlying stock).

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