As markets swing between optimism and anxiety, many seasoned traders may turn to options as a hedging strategy. Whether their goal is to shield a portfolio from downturns or guard against single-stock volatility, hedging using options to protect against potential loss is a go-to strategy in uncertain times. Traders also use options to speculate on future price moves, generate income, and protect their positions against losses, especially when the financial markets are volatile.
A simple put option, for example, can cap downside losses on a stock or market index, while more complex strategies like collars and spreads can preserve gains without sacrificing all upside potential.
Think of options contracts as a form of insurance that gives their owners the right, but not the obligation, to buy or sell an asset on a specified expiration date at a predetermined exercise price. Hedging with options can help traders stay invested in the market during times of uncertainty or volatility while also managing downside risk. Rather than trying to predict the next move, traders who use options to hedge can prepare for a move that goes against them. As with insurance, there is an expense to hedging with options.
When and how to hedge with options
There's limited hedging traders can do against a Black Swan market event, but they can sometimes spot impending volatility or downside and hedge against it. Market declines usually begin as pullbacks (declines of less than 10%), turn into corrections (declines between 10% and 20%), and occasionally become bear markets (declines of more than 20%). And the bottom doesn't usually arrive immediately. Below, we'll review some strategies that you may be able to use both before and after the decline has started.
Buying puts
Put option owners have the right to sell the underlying equity at a specified price, and call option owners have the right to buy. The easiest way to hedge against expected downside using options is to buy a protective equity put option.
A trader who's concerned about an existing long stock or exchange-traded fund (ETF) position falling in value can buy a put, giving them the right to sell the underlying position at a defined exit price. A protective put can also be used to hedge an entire portfolio.
Hedging a single stock
A trader who holds shares in ZYX may be concerned about the stock dropping in value from its current level of $100. They're willing to accept a 20% decline but no more. So, they purchase options on ZYX with a strike price of $80. If ZYX's price falls to $75, then the option can be executed at $80, offsetting the amount of the loss in the shares.
Protective puts provide significant downside protection. The trade-off is that they can be expensive, particularly in times of market volatility. And if the stock's decline isn't as dramatic as projected, the put may eventually expire worthless.
Hedging a portfolio
Options on ETFs, market indexes, and futures contracts can be used to hedge entire portfolios. For example, a trader with a portfolio that's closely correlated to the S&P 500® index (SPX) might want to buy protective puts on the index to hedge against a broad-market decline. These types of options settle in cash. If the index value falls and the put goes in the money, the trader can exercise it at expiration and receive cash based on the strike price of the option, rather than having to sell a basket of stocks.
ETFs, futures, and index options can also be used to hedge a portfolio against a downturn in specific market sectors. A trader who owns a lot of health care stocks might want to buy puts on a health care index to hedge against a downturn in that industry, while a trader with exposure to energy companies could consider buying a put option on oil futures contracts.
Hedging with multi-leg options strategies
The main drawback of a protective put is the cost. Spreads, collars, and other strategies that involve an equal number of long and short options tend to neutralize much of the impact of volatility changes, allowing the focus to become strictly directional (based on price). Because a trader needs to buy and sell options to trade these strategies, they tend to come at a lower overall cost than a single-option hedge like a protective put.
The downside of multi-leg strategies is that they can be complicated to set up and limit the upside potential of the overall position.
Setting up a collar
A collar consists of three parts: a long stock position, a long (bought) put, and a short (sold) call. The options traded in a collar will have the same expiration date but different strike prices, typically with the put strike below the current stock price and the call strike above it. The revenue from selling the call offsets some or all the cost of the put.
Once in place, this collar can provide significant downside protection. The downside is that if the short call options go in the money, the option could be assigned, meaning the trader must unload their underlying shares (100 for each sold call). This takes away the underlying stock position, limiting the upside potential. Stocks that pay dividends can be especially vulnerable to early assignment.
Setting up a collar plus a put spread
One way to further reduce the cost of a downside options hedge is to add a put spread to a collar. This trade involves a long position in a stock, a short call, and two puts: a long put at one strike price and a short put at a lower strike price. All the options will have the same expiration date, and all options should be out of the money.
Because the trader collects two options premiums instead of just one in a traditional collar, the put spread collar may be costless or even generate net premium revenue. There are two trade-offs. One is greater complexity, and the second one is if the stock falls below the strike price on the long put, the trader will have to buy back the short put (almost definitely at a loss) or face assignment. Additionally, while downside losses can be substantial in the case of a large price drop in the stock, upside potential is limited if there's a large move to the upside.
Bottom line
Protective puts, whether used alone or as part of multi-leg options positions, can protect investment holdings against extreme downward price movements in times of volatility. Of course, using options to hedge against adverse market movements involves trade-offs. Traders should consider focusing only on those positions in their portfolios that tend to have the greatest price fluctuations—or those that make up a substantial position of their accounts—and limit their hedging activity to periods of notable market volatility.
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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any option transaction. Supporting documentation for any claims or statistical information is available upon request.
Multiple leg options strategies will involve multiple transaction costs.
Covered calls provide downside protection only to the extent of the premium received and limit upside potential to the strike price plus premium received.
Spread trading must be done in a margin account.
With long options, investors may lose 100% of funds invested.
Past performance is no guarantee of future results.
Investing involves risk, including loss of principal, and for some products, loss of more than your initial investment.
Hedging and protective strategies generally involve additional costs and do not assure a profit or guarantee against loss.
Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment products and investment strategies mentioned are not suitable for everyone. Each investor needs to review each transaction for their own particular situation.
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