4 Ways to Hedge Your Stock Bets

12/10/2012 8:00 am EST


Beth Gaston Moon

, Schaeffer's Investment Research, Inc.

As you may already be aware, hedging is a popular options strategy—and why not? Beth Gaston of Schaeffer's Investment Research offers four common ways to hedge your market bets with options.

Options offer a reasonably priced, low-risk method of protecting against major losses on your equity investments. This article highlights four general ways you can use option contracts to hedge your market positions.

Protect Individual Stock Investments
First off, we have the protective put, which is also referred to as a "married put." As you may already be aware, buying (to open) a put option gives you the right, but not the obligation, to sell 100 shares of the underlying stock at the strike price of the contract. This bearish strategy is described as a "long put."

So, let's say that you own 1,000 shares of Stock XYZ. It's a relatively solid stock that you've held in your portfolio for a while, yielding a considerable gain of 155%. Ideally, you'd like to keep your shares, since you're collecting a respectable dividend and you are encouraged by the company's long-term prospects.

However, there's a recent fundamental development that has made you a bit nervous. XYZ's CEO of 25 years has departed the company, and you're anxious that the shift to a new chief executive could have a negative impact on the stock price.
In this scenario, there's no need to panic-sell the shares—nor do you need to sit by helplessly and watch your profits erode. Instead, you can ease your anxieties by buying a protective put. To implement the strategy, simply buy (to open) one put option for every 100 shares you'd like to insure (in this case, you would need 10 puts to protect all 1,000 shares).

There are no strict rules, but try to match the strike price of your puts with your preferred exit price on the stock. If XYZ is hovering at $58 per share, and you don't want to own the shares below $50, considering buying the 50-strike puts. Meanwhile, choose a time frame that aligns with your expected period of weak (or uncertain) price action. In this example, you'll probably have a good idea after three months or so whether you should head for the exits, or hold onto the stock.

If your fears come to fruition and the stock declines, your put options will go in the money. You can then exercise your option to sell the shares at the strike price, thereby securing a comfortable exit price. In other words, the purchase of the put options has capped your downside risk.

However, even if the puts expire worthless, there's an upside: you still own a stock on which you're bullish long-term. Plus, the protective puts have given you peace of mind, which could help you rest a little easier at night.

NEXT PAGE: Guard Against Sector & Broad Market Mayhem |pagebreak|

Guard Against Sector-Specific Weakness
As the popularity of exchange-traded funds (ETF) continues to grow, there is an array of hedging opportunities. There are now ETFs available on nearly every sector of the market, which is great news for speculators.

Let's take a look at this example. If you own a variety of large-cap tech stocks, it would be pretty tedious to buy a protective put on each individual security (not to mention it would cost you a bundle in brokerage fees). However, that doesn't change the fact that you're concerned about the potentially negative effects of a slowdown in corporate IT spending.

If you expect this fundamental development to have an ill effect on some of your tech holdings, but you'd prefer to keep the shares over the long term, simply find an ETF that's based on the sector in question. In this example, it would be the PowerShares QQQ Trust, Series 1 ETF (QQQ), which tracks powerhouse stocks such as Apple (AAPL), Microsoft (MSFT), and Intel (INTC). To hedge your large-cap tech investments, purchase one put option per 1,000 shares you'd like to insure.

The possible outcomes here are roughly the same as with a straightforward protective put. However, bear in mind that ETFs won't necessarily track the movements of your stocks directly, due to their unique compositions. For example, AAPL controls a much larger percentage of the QQQ compared with INTC. So, you could theoretically lose money on your Intel shares, while the QQQ remains perched above the strike price of your puts, due to a simultaneous surge in AAPL shares.

Happily, though, a large number of sectors have more than one dedicated ETF, so you should be able to pick and choose. Be sure to do some research before you purchase put protection, as it definitely pays to keep an eye on the weighting assigned to each asset within the ETF.

Last but not least, it bears mentioning 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 ready to sell. Rather, if your option goes in the money, you can simply sell to close prior to expiration in order to lock in a gain.

Shield Your Portfolio From Broad-Market Mayhem
The natural progression of this idea is to purchase protective puts on the entire equities market. This is a handy strategy during bear markets, bull-market pullbacks, or other periods of generally lackluster price action for securities.

Admit it: even in the worst of all possible markets, you're probably not going to empty your entire portfolio and run for the hills. Even so, it's never pleasant to watch your losses mount. Even if you're a firm, long-term buy-and-holder, nobody wants to see their profits dwindle.

Luckily, put options enable you to profit from negative price action, whether in a single equity or the entire market. By buying puts on an index, you can gain even while your portfolio flounders.

NEXT PAGE: Cover Your Shorts |pagebreak|

The concept here is similar to the ETF hedge. However, it's worth noting that a number of options on broad-market indexes are European-style, which means they offer limited flexibility. Also, if you check out an option chain for the S&P 500 Index (SPX), you'll see that they're not very liquid.

Alternatively, those seeking to hedge against widespread weakness often turn to the S&P Depository Receipts, aka the SPDR S&P 500 ETF Trust (SPY). This ETF is based directly on the movements of the SPX, but at a fraction of the cost. SPY options are both reasonably priced and liquid, and offer an ideal way to hedge against the broader equities market.

Of course, depending on the makeup of your portfolio, you might be better off employing the SPDR Dow Jones Industrial Average ETF (DIA), based on the Dow Jones Industrial Average (DJI), or the iShares Russell 2000 Index ETF (IWM), which is based on the small-cap rich 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 gains. Still, the utilization of index puts can ideally help cap your downside risk, and again, give you with peace of mind during periods of market uncertainty.

Cover Your Shorts
Our last hedging alternative is a little different from the rest, as it involves using calls rather than puts. Short sellers might get a lot of grief and take a lot of blame, but they need to hedge sometimes, too, just like everybody else.

As you may have already noticed, we usually prefer put options over short selling. However, rest assured that we won't chastise you if you decide to sell a stock short. However, it can be a risky strategy if the underlying stock unexpectedly treks higher.

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 gain the right to purchase the stock at the strike price of the contract.

For example, say you shorted Stock XYZ when it was trading at $30. The shares have since declined to $18, proving your theory correct. But, unfortunately, the equity surged to $24 after a positive earnings report, and your profits are dwindling rapidly.

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 obtained the right to purchase the shares at $25 each. Even if XYZ rallies up to $32, which would have placed your unhedged short sale at a loss, you can still come out victorious.

In summation, there's no limit to the number of ways you can hedge your bets with options. As a final note, however, be sure that you're not hedging when you should be closing out a losing position. It's always a good idea to re-examine your initial rationale for the trade, and make sure your analysis is still sound, before choosing your next move.

By Beth Gaston, Senior Editor and Writer, Schaeffer's Investment Research

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