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Hedging with Options

Jeff BishopJeff Bishop ·

If you’re an investor, especially one who believes in buy and hold, then you should learn about hedging. Portfolio protection is essential, especially when stocks start crashing. That said, you can use options to protect single stock positions or your entire portfolio.

What is Hedging?

The reason investors hedge is because they want to insurance against a stock market collapse.

When trying to grasp the concept, think of healthcare.

For example, when you buy insurance, you pay a premium for a certain level of protection. For example, healthcare insurance can vary in price and coverage. That said, hedging isn’t always about protecting your portfolio against a black swan event, you may want to hedge against an unknown outcome like an earnings event or other known catalysts.

Hedging Methods

There are several ways a trader can hedge their portfolio. Let’s examine some of the more common methods.

1. Options. One of the fastest and easiest ways to hedge your stock exposure is by buying puts. A put option acts as a built-in stop loss. When you purchase a put option you are paying a premium for stock protection.

2. Stocks.  This can be achieved by trading inverse-ETFs and volatility ETNs. However, for the average investor, trading those instruments are complex and potentially too risky. That said, I primarily stick to options trading because they offer a number of benefits.

volatility trading and hedging

Benefits of Options

1. You don’t need a large trading account.

2. You can define your risk.

3. Leverage. For as little as $500 you can control 100 shares of some of the largest companies in the world.

4. Potential for fast cash. You just need to see small stock moves to make big bucks with options because of leverage.

However, when you’re hedging, you’re thinking defense, not offense. Hedging is an expense, just like most other forms of insurance.

Option Hedging Strategies

As previously mentioned, the fastest and easiest way to hedge is by buying put options. However, if you’re new to options, an options chain can be overwhelming. For example, answering questions like which strike should I buy? can be overwhelming. Not to mention all the different expiration periods there are to chose from. That said, let’s look at the different levels of protection different put options offer.

Hedging Examples

In this example, a trader is looking to hedge against a known catalyst, Apple Inc.’s Q4 2018 earnings release.

aapl options chain

(Source: thinkorswim)

Above you’ll see an option chain of Apple Inc, hours before it announces its earnings results. That said, options are priced rich because of the catalyst.

Out-of-the-money Options

Apple’s stock price is trading at $155.17 per share.

The $150 puts expiring in three days are trading for $2.37. What level of protection does that give you?

To figure out the break-even level, you’ll take the strike price and subtract it by the premium of the put option. In this case, it’s $147.63.

Now, those same strike options, $150 puts, trade for $4.10, for the contracts that expire 31 days from now. Your break-even mark is $145.90. If you go out further, say 79 days out, those same $150 puts trade for about $5.90.

Lesson: The farther you go out, generally speaking, the more expensive options will be. Also, the higher the implied volatility, the more expensive options will cost.

At-the-money Options

These options refer to the strike price that is closest to what the stock is trading at. In the example above, it would be the $155 puts.

They are valued at $4.35 with three days till expiration. In other words, if you are long the stock, and you hedge with ATM puts, you’re liable for only about 3% of downside.

In-the-money Options

The $160 put strike would be an example of a put option that is ITM. The option has a value of 7.10. However, if you subtract 160 from the stock price, this option has almost $5 of intrinsic value. That said, it offers more protection than the $150 and $155 puts.

Hedging For The Worst

Options are at their most expensive ahead of a catalyst. However, after the outcome of the event is known, option premiums deflate. That said, that is the best time to put on long-term hedges. Now, if you have a basket of stocks, a diversified portfolio, then you might want to consider exploring hedging with index options or ETFs. For example, buying puts in the SPY, IWM, DIA, or QQQ might be a sufficient hedging strategy if your portfolio resembles them enough. Furthermore, industry-specific ETFs could be another way to go. For example, SPDR has ETFs for energy, health care, technology, utilities, and much more.

If you fear the worst, consider deep out-of-the-money puts. These are options that are very low in premium and have a low probability chance of ever being profitable. However, for hedging purposes, it doesn’t offer you much near or medium-term protection. But it could save you some money if there is a sizeable premarket move lower.

Final Summary

Sophisticated investors can use stocks to hedge. Pairs trading is a strategy some professionals use. For example, let’s say you thought one stock was going to outperform the sector. So you might consider buying JPMorgan Chase and shorting a financial ETF that includes all the top banks.
As you can see, while this strategy might sound appealing to the professional, it’s too complicated and expensive for most retail traders. However, using options as a way to hedge is easy and can save you some money. If you’d like to know more about becoming a better options trader, make sure to read my latest eBook, 30 days to options trading.

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