Most traders think of options like an offensive arsenal of weapons they can use to speculate on big moves in an underlying stock. Options can be excellent for that purpose. However, options can also be excellent defensive tools. In this article, we’ll explore what options are and how they can be used to hedge a portfolio.
Investors often look for ways to minimize their portfolio risk and protect their assets from potential market downturns. One effective strategy to achieve this is through hedging with options.
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What are options?
If you’re familiar with Market Rebellion, you’re likely familiar with options already. But in case you aren’t, here’s the quick run down:
Options are financial instruments that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price, known as the strike price, on or before a specific date, known as the expiration date. The two most basic types of options are call options and put options.
A call option gives the holder the right to buy the underlying asset at the strike price, while a put option gives the holder the right to sell the underlying asset at the strike price. Options are traded on various assets such as stocks, indexes, commodities, currencies, and even cryptocurrency. That means whether your portfolio is crypto, equities, commodities, or a diversified mix of everything, you can protect your portfolio with options.
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How can options be used for hedging?
Options can be used to hedge a portfolio by providing downside protection against potential market downturns. Think: Making a contrarian play against yourself for a limited cost, using leverage. Sound confusing? Here are a few ways to do it.
Protective Put Strategy
A protective put strategy involves buying a put option on the underlying asset that is held in the portfolio. This put option acts as an insurance policy against a market downturn. If the market falls, the put option will increase in value, offsetting the losses in the underlying asset. If the market rises, the put option will expire worthless, but the investor can still participate in the gains using their long term portfolio.
The goal of a protective put is not to benefit from gains in the put option, but to provide your portfolio a cheap, protective shield in the event of a downturn.
For example, if an investor owns 100 shares of XYZ stock, which is currently trading at $50 per share, and buys a put option with a strike price of $45 for $2 per share, the investor is protected against any losses below $45 per share. If the stock falls to $40 per share, the investor can exercise the put option and sell the shares for $45 per share, thereby limiting the loss to $3 per share ($5 drop in stock price minus $2 cost of the put option).
The protective put is excellent if you’re anticipating a potential drop in your holdings – but the protective put is long volatility, and theta negative. That means the protective put requires a steep downward move in the underlying in order to adequately protect a portfolio.
If you’re looking for a softer approach, one that takes advantage of the passing of time, or that can even help hedge or power-up your portfolio during times where stocks are stagnant, look no further than the covered call strategy below.
Covered Call Strategy
A covered call strategy involves selling a call option on an underlying asset that is held in the portfolio. This generates income for the investor, but also limits the potential upside. If the market rises above the strike price of the call option, the investor will have to sell the underlying asset at the strike price, but will still participate in the gains up to that point.
For example, if an investor owns 100 shares of XYZ stock, which is currently trading at $50 per share, and sells a call option with a strike price of $55 for $2 per share, the investor generates income of $200. If the stock rises to $60 per share, the investor will have to sell the shares for $55 per share, but will still have made a profit of $5 per share ($10 increase in stock price minus $5 difference between the strike price and the current price).
A collar strategy involves combining a protective put strategy and a covered call strategy. This strategy involves buying a put option on the underlying asset and selling a call option on the same asset with a higher strike price. This provides protection against downside risk and limits potential upside, but also has the potential to generate income.
For example, if an investor owns 100 shares of XYZ stock, which is currently trading at $50 per share, the investor can buy a put option with a strike price of $45 for $2 per share and sell a call option with a strike price of $55 for $2 per share. This provides protection against losses below $45 per share and limits potential gains above $55 per share. The investor also generates income of up to $200.
Conclusion: Options are a Diverse Toolbox
A master carpenter doesn’t show up to a job with just one tool. “I’m here to renovate your house! I only bought my hammer.” Likewise, elite options traders must be ready to deploy any number of offensive or defensive options strategies depending on the market environment. That’s why knowing how to hedge with options is so important.
Hedging a portfolio with options can provide downside protection against potential market downturns, and with a little creative thinking, can even be used to hedge other option positions. (Discover how to use diagonal spreads inside this link!) Investors can use strategies such as protective puts, covered calls, and collars to rest easy during turbulent times, and even make a couple of extra bucks!
But selling covered calls can take some nuance in order to perfect. If you’re interested in seeing how a professional option trader uses covered calls to hedge his portfolio, look no further than Pete’s Covered Calls! Pete’s Covered Calls, gives you the inside look at Market Rebellion Co-Founder Pete Najarian’s stock portfolio, and the options he’s selling to capture premium and mitigate downside risk. Discover what he’s selling and what he’s buying the second he opens a new position with Pete’s Covered Calls.