Hedging stocks with put options
For example, you can speculate that the market price will rise in the future and buy a call today. But, because the market is uncertain and you're not certain it will rise, you simultaneously buy a put option. By carefully selecting the appropriate combinations of strike price, expiration date and type of option an investor can minimize risk and maximize the probability of making a profit.
So how does it all work? Well let's take a look at a common hedging strategy: the Strangle. In this strategy, an investor holds both call and put options with the same maturity, but with different strike prices. The contracts are purchased 'out of the money' and are therefore cheaper. So that's your net profit ignoring commissions and taxes.
The difference between the exposure and the potential profit represents a kind of hedge. Though you are essentially 'betting' that the price could go either way, your downside is limited to the combined cost of the put and the call. There are, not surprisingly, nearly as many hedging strategies as there are investors. A couple of common types are: The collar: Hold the underlying asset and simultaneously both buy a put and sell a call of the same asset.
The short call limits gains, but the long put hedges against any losses from the underlying asset. The protective put: Buy the asset and also buy a put option on the same asset. At expiration, the asset may have gained eliminating the value of the put option , but the rise in the asset offsets the loss.
So should I hedge my portfolio with index put options?
And there are a whole host of other variations. Most do involve speculating on the price direction of the underlying asset, while taking advantage of the leverage, cost and timing characteristics of options. As with any investment strategy, make sure you understand the pros and cons before laying down your bet. Editorials » Business Resources » Trading ».
How to hedge with options
A hedge is a strategy that mitigates against the risks to an investment. In many cases a hedge is an instrument or strategy that appreciates in value when your portfolio loses value. The profit on the hedge therefore offsets some or all of the losses to the portfolio. There are several different risks that can be hedged. Moreover, there are numerous strategies to hedge these risks.
Some portfolio hedging strategies offset specific risks, while others offset a range of risks. In this article we are focusing on hedging stock portfolios against volatility and loss of capital. However, portfolio hedging can also be used to hedge against other risks including inflation, currency risk, interest rate risk and duration risk.
You can implement a hedge to protect an individual security. However, if individual securities carry risk, it makes more sense to reduce or close the position. Investors typically want to protect their entire stock portfolio from market risk rather than specific risks. Therefore, you would hedge at the portfolio level, usually by using an instrument related to a market index.
You can implement a hedge by buying another asset, or by short selling an asset. Purchasing an asset like an option transfers the risk to another party. Short selling is a more direct form of executing a hedge. Hedges are very seldom perfect, and if they were, they would serve no real function as there would be no potential for upside or for downside. In many cases only part of the portfolio will be hedged. The goal is to reduce risk to an acceptable level, rather than removing it. As mentioned, there are many different ways of hedging stocks. We will start with five approaches using options, and then consider five other approaches to portfolio hedging.
An option contract is an agreement that gives the buyer the right, but not the obligation to buy or sell an asset at a specific price.
Using Options to Hedge or Enhance Your Stock Portfolio | STA Wealth Management
In some cases, an option can be executed anytime before the expiry date, and in others it can only be executed on the expiry date. A call option gives the holder the right to buy the underlying instrument at the strike price. A put option gives the holder the right to sell the underlying asset at the strike price and is therefore most commonly used for hedging purposes. For put options, the option is said to be in the money if the current spot price is below the strike price. The option is out of the money if the strike price is below the spot price.
The price paid for an option is the premium. Deep in the money options are more expensive as they have intrinsic value. Options that are a long way out of the money have very little value, as there is little chance they will expire with any intrinsic value. The objective of an option hedge is to reduce the impact of a market decline on a portfolio. This can be achieved in a number of ways — using just one option, or a combination of two or three options.
The following are five option hedging strategies commonly used by portfolio managers to reduce risk.
A long-put position is the simplest, but also the most expensive option hedge. A collar entails buying a put option and selling a call option. By selling a call option, part of the cost of the put option is covered. The trade-off is that upside will be capped. If the index rises above the call option strike price, the call option will result in losses. These will be offset by gains in the portfolio. A put spread consists of long and short put positions.
Again, the sale of the put will offset part of the cost of the bought put.
Put Options
If the spot price falls below the lower strike, gains on the long put will be offset by losses on the short put. A fence is a combination of a collar and a put spread. This entails buying a put with a strike price just below the current market level and selling both a put with a lower strike price and a call with a much higher strike price.
The result is a low-cost structure that protects part of the downside while allowing for some upside. A covered call strategy involves selling out of the money call options against a long equity position.
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This strategy is usually used on individual stocks. If the stock price rises above the strike price, losses on the option position offset gains on the equity position. Holding cash is one way to reduce volatility and downside risk. The less a portfolio has allocated to risky assets like equities, the less it can lose during a stock market crash. The trade-off is that cash earns little to no return and loses buying power due to inflation. Diversification is one of the most effective ways to hedge a portfolio over the long term.
By holding uncorrelated assets as well as stocks in a portfolio, overall volatility is reduced. Alternative assets typically lose less value during a bear market, so a diversified portfolio will suffer lower average losses. Unlike cash, alternative assets generate positive returns over time, so they are less of a drag on performance. Hedge funds can also generate positive returns during a bear market because they hold long and short positions. Because this fund responds to changing market conditions so quickly and holds long and short positions it acts as a hedge against volatility and downside risk.
Short selling stocks or futures is a cost-effective way of hedging stocks against an expected short-term decline. Selling and then repurchasing stocks can have an impact on the stock price, while there is minimal market impact from trading futures. Selling a futures contract is a cheaper more efficient means of reducing equity exposure.