If you’re an investor, especially one who believes in buy-and-hold methods, then you should learn about using hedging to your advantage. Portfolio protection through hedging is essential, especially when stocks start crashing. That said, you can use options to protect single stock positions or your entire portfolio.
If you’re new to the world of trading, learning the basics of hedging should be at the top of your to-do list. But even experienced traders can always use a recap in the powers of hedging strategies. Here’s a quick, in-depth look into what hedging can do for you:
What is Hedging?
The reason investors hedge is because they want insurance against a stock market collapse. Using hedging strategies is an intelligent way to protect your livelihood as a trader, and your assets.
When trying to grasp the concept of hedging, 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. Hedging works in a similar way — it’s a premium you pay for the protection of your trades. 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.
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. Hedging with options is a great way to reduce the risks involved with making the purchase, but it also reduces your potential profit.
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.
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 choose from. That said, let’s look at the different levels of protection different put options offer.
In this example, a trader is looking to hedge against a known catalyst, Apple Inc.’s Q4 2018 earnings release:
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.
Apple’s stock price is trading at $155.17 per share.
The $150 put options that are 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, or ATM, 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 3 days till expiration. In other words, if you are long on the stock, and you hedge with ATM puts, you’re liable for only about 3% of downside.
The $160 put strike would be an example of a put option that is in-the-money, or 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. 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 implement a hedging strategy. For example, SPDR has ETFs for energy, health care, technology, utilities, and much more.
If you fear the worst, consider hedging with deep out-of-the-money put options. 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.
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. That’s where hedging with options comes in. 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. My goal is to give you the resources you need to become a successful options trader. Put options, call options, hedging strategies, and more — you’ll be that much closer to trading success after reading your free copy of my eBook.