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Your Fast Track Program To Unlocking Options Clearance

Options Academy | Jeff Bishop | July 9th, 2020 |

Using Options to Hedge

Protective Put

A protective put is a put option which is purchased against a long stock position. When you buy a protective, or married, put, the goal is not to make money, but to save it. Furthermore, a protective put will cut into your profit potential. It works the same way insurance does: you pay for certain levels of coverage. And like insurance, you select how much coverage you need.

The cheapest form of “insurance” you can get is buying out-of-the-money options, but you get what you pay for.

Let’s take a look at an example.

Apple (AAPL) shares are currently hovering near $190, which, for a trader who is long 1,000 shares of AAPL, creates a stock position of $190,000. They’re nervous about a near-term pullback, and decide to buy 10 out-of-the-money 165-strike puts for $9.05, or $9,050, since each option contract accounts for 100 shares.

In one scenario, AAPL crashes, and drops by 40% or more. A 40% drop would take the stock down to $114. If the trader is long only, they would be down $76,000 in the position. However, if they hedged with the $165 puts, they would lose about $34,000. That said, the 165 puts only act as a hedge on drops of 20% or more.

To get more protection, they could buy 10 at-the-money 190 puts for $18.90 each, or $18,900. This means coverage kicks in on a drop below breakeven at $171.71 (strike less premium paid).

In-the-money puts offer the most protection for long stock positions. Using the example above, let’s say this trader buys 10 195-strike puts for $21.25 each, or $21,250. This puts breakeven at $173.75, which means the long Apple position is fully hedged on a move below $173.75.

Collar/Risk Reversal

The collar, or risk reversal, is best-suited for those who are bullish, but a bit anxious about the stock falling. The setup for a collar involves a long position in the underlying stock, a long put option at a specific strike price, and a short call option at a higher strike. For this strategy, the stock price would be somewhere between the put and the call strikes.

The collar is basically the same as combining a covered call with a protective put. This strategy has limited downside risk, but it also has limited upside potential. There are two breakeven points for a collar strategy, depending on if you initiated it for a net credit (breakeven is the current stock price less the net credit) or a net debit (breakeven is the current stock price plus the net debit).

In order to hit your maximum profit potential — which is capped at the difference between the call strike and the stock price, plus the net credit or minus the net debit — you would want the stock price to rise above the short call strike. Your maximum potential loss is limited to the current stock price less the put strike plus or minus the net debit or credit, respectively.

A collar is a neutral trade situation, protecting investors if the stock price decreases, but perhaps obligating them to have to sell their long stock at the short call strike, although they will have already experienced increases in the underlying stock.

A good example is if a trader initially went long 100 shares of Disney (DIS) at $60, but the stock has since risen to $120. The trader could create a protective collar by selling one 125-strike call, while simultaneously buying one 115-strike put. They are now protected below $115 (site of the bought put strike) through options expiration, with the trade-off being they will potentially be obligated to sell their shares at $125 (site of the sold call strike).

Wrapping Up

Clearance for level one trading with options allows speculative players to dip their toes into derivatives with defined risk — using options to hedge against a long stock position. When stocks are trending higher, hedging looks like a bad expense. But when you’re hedging, you’re thinking defense, not offense, which is why during periods of uncertainty and market sell-offs, the hedged trader takes the least amount of damage. With options, there are several ways to protect your portfolio at the most basic level, namely covered calls, protective puts, and collars.

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