4 Ways to Hedge Using Options

03/24/2011 9:07 am EST

Focus: OPTIONS

Options can be relatively low-cost, low-risk hedging tools for stock investments. Here are four common ways in which option contracts can be used to hedge your bets in the market.  

By the Staff at Schaeffer’s Investment Research

As you may already be aware, hedging is a particularly popular use for options...and why not?  Options offer a relatively low-cost, low-risk method of insuring against major losses on your stock investments. In this column, we'll examine four common ways you can use option contracts to hedge your bets in the market.  

1. Protect Individual Stock Investments

First up, we have the aptly named protective put, which also goes by the alias "married put."  Buying (to open) a put option gives you the right, but not the obligation, to sell 100 shares of the underlying equity at the strike price of the contract. This bearish bet is described as a "long put."

So, let's imagine that you own 1,000 shares of stock XYZ. It's a relatively reliable stock that you've held in your portfolio for a couple of years, collecting a respectable gain of 155% in the process.  Ideally, you'd like to hang onto your shares, since you're collecting a healthy dividend and you think the company's long-term prospects are solid.

However, there's a recent fundamental development that has made you a little anxious. XYZ's CEO of 25 years has retired, and you're jittery that the shift to a new chief executive could have negative effects on the share price.

In this scenario, there's no need to panic sell the stock, nor do you need to sit around and watch your profits dwindle. Instead, you can soothe your jittery mind by purchasing a protective put. To execute the strategy, simply buy (to open) one put option for every 100 shares you'd like to insure (in this case, you would need ten puts to protect all 1,000 shares).

There are no hard and fast guidelines, but try to align the strike price of your puts with your desired exit price on the stock, should the worst-case scenario come to pass. If XYZ is sitting at $58 per share, and you don't want to own the shares below $50, avail yourself of 50-strike puts. Meanwhile, select a time frame that corresponds with your expected period of weak (or uncertain) price action. In this example, you'll probably have a good idea within three to six months of whether you should bail out or keep holding the stock.

If the security plummets, as you feared, your put options will go in the money. You can then exercise your option to sell the shares at the strike price, thereby locking in a comfortable exit price. Essentially, the purchase of the put options has placed a very concrete floor on your downside risk.

But, even if the puts expire worthless, there's an upside: You're still holding a stock on which you're bullish long term. Plus, the protective puts have provided you with peace of mind, which, as any insurance commercial worth its salt will tell you, is virtually priceless.

2. Guard Against Sector-Specific Weakness

Thanks to the ever-growing popularity of exchange traded funds (ETFs), your hedging opportunities are almost endlessly diverse. There are now ETFs available on pretty much every sector of the economy, every region of the world, and soon, I imagine, companies whose names begin with the same letter! This is great news for traders, especially those of you who are feeling downright “hedgey.”

Let's dive into an example, shall we? If you own a variety of large-cap tech stocks, it would be a giant pain to purchase a protective put on each individual equity (plus, it would cost you a slew of brokerage fees). However, that doesn't change the fact that you're concerned about the possible ill effects of sluggish corporate information technology (IT) spending.

If you expect this fundamental development to negatively impact some of your tech holdings, but you'd ideally like to keep the shares during the long run, you could locate put options on an ETF that's based on the sector in question. In this example, it would likely be the PowerShares QQQ Trust (QQQ), which tracks such heavy hitters as Apple (AAPL), Microsoft (MSFT), and Intel (INTC). 

The possible outcomes here are approximately the same as with a straightforward protective put on an individual stock. But, keep in mind that ETFs won't necessarily track the movements of your stocks directly, due to their unique compositions.  For example, AAPL accounts for 20.5% of the QQQQ, while INTC is just about 2%. So, you could potentially lose money on your Intel shares, while the QQQQ remains stubbornly above the strike price of your puts due to a simultaneous rally in AAPL shares.

Happily, though, a great number of sectors have more than one ETF dedicated to their every movement, so you should be able to shop around. Do your research before you buy put protection, because it definitely pays to keep an eye on the weighting assigned to each asset in the ETF. You probably won’t find an exact match to your portfolio, but you can get close, especially if you are heavily into a specific sector such as technology or finance.

Finally, in this scenario, it's worth noting that you will most likely not be exercising your option--as you would with a protective put--unless you happen to have a couple hundred shares of the appropriate ETF handy to sell. Instead, if your option goes in the money, you can simply sell the contract(s) to close prior to expiration in order to lock in a gain on the position.

NEXT: For Protecting Against Broad-Market Mayhem

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3. Shield Your Portfolio from Broad-Market Mayhem 

The natural extension of this idea is to purchase protective puts on the entire equities market. This is a nifty trick during bear markets, bull market pullbacks, or other periods of generally weak or volatile price action for stocks.

Let's face it: Even in the worst of all possible markets, you're probably not going to dump your entire portfolio and head for the hills (unless you're a "stashing money in the mattress" type, in which case, you just might). However, there's nothing quite as unpleasant as watching losses add up. Even if you're a staunch, long-term buy and holder, nobody likes to watch their investments suffer.

Luckily, put options allow you to profit from negative price action, whether in a single stock or the entire market. By purchasing puts on an index, you can benefit even while your portfolio struggles.

The concept here is similar to the ETF hedge. However, it's worth noting that many options on broad-market indexes are European-style, and thus offer limited flexibility. Plus, if you check out an option chain for the S&P 500 Index (SPX), you'll notice that they're not terribly liquid.

Instead, the multitudes looking to hedge against widespread weakness often turn to the S&P Depository Receipts, the SPDR S&P 500 ETF (SPY). This ETF is based directly on the movements of the SPX, but at a fraction of the cost. SPY options are both affordable and liquid, and offer a convenient vehicle for hedging against declines in the equities market as a whole.

Of course, don't buy SPY options just because we said so. Depending upon the makeup of your portfolio, you might be better off using the SPDR Dow Jones Industrial Average (DIA), based on the Dow, or the iShares Russell 2000 Index ETF (IWM), which is based on—you guessed it—the Russell 2000 Index (RUT).

As with any ETF hedge, you're not necessarily going to get a perfect inverse correlation between your stock losses and your put-related profits. However, the use of index puts can ideally help to limit your downside risk, and again, provide you with peace of mind during periods of market uncertainty. 

4. Cover Your Shorts

Our last hedging alternative is a deviation from the rest because it centers around calls rather than puts. Short sellers might catch a lot of flak and take a lot of blame, but they need to hedge sometimes, too, just like everybody else.

As you might have heard us colleagues mention, we generally prefer put options over short selling.  However, rest assured that we won't judge you if you decide to sell a stock short. I will warn you, though, that it can be a quite risky strategy if the underlying stock unexpectedly rallies.

So, how do you hedge a short stock position? Simply purchase a long call. By buying to open a call option on the stock you've shorted, you obtain the right to buy the shares at the strike price of the contract.

Let's say that you shorted stock ZYX when it was trading at $30. The shares have since plummeted to $18, proving that you're quite the prognosticator. But, unfortunately, the stock rallied up to $24 after an upbeat earnings report, and your profits are shrinking fast.  

In order to hedge your position, you could buy to open an out-of-the-money call option; in this case, the $25 strike would work. Then, you could lock in a profit of $5 on the trade, because you've purchased the right to buy the shares at $25 each. Even if ZYX rallies up to $32, which would have placed your unhedged short sale at a loss, you can still emerge a winner.

In short (no pun intended), there's no limit to how many ways you can hedge your bets with options.  As a final caveat, though, make sure that you're not hedging when you should be closing out a losing position. It never hurts to re-examine your initial rationale for the trade and making sure that your analysis still holds water before deciding how to proceed.

By the Staff at Schaeffer’s Investment Research

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