By Wayne Duggan
Stock traders sometimes see the option market as complicated, volatile and intimidating. While it’s true that some option trading strategies are extremely complex, there are also some simple strategies that can help stock traders and long-term investors hedge the risk in their portfolios. Here’s a breakdown of two simple option hedging strategies.
1. Buying Puts
Buying put options may be the closest thing to actual insurance for your stock investments. A put contract gives the buyer the option of selling 100 shares of a stock at a specific price, the strike price, on a specific date in the future. Buying puts can give investors a direct hedge against their stock holdings at any price they choose.
For example, if you own a stock trading at $40 per share, you can choose to buy put options to match the size of your stock holding that expire 1 year into the future and have a strike price of $30. If your stock’s share price then drops down to $15 per share, those put contracts give you the option of selling your shares at $30. Instead of taking a $25-per-share loss, you’ve only taken a $10-per-share loss.
The only caveat to this strategy is the option premium, or the cost of buying the put contracts. The further below the current share price the put contract’s strike price is, the cheaper the contracts will be and the more potential losses you will be exposed to. A put contract on a $40 with a strike price of $30 and an expiration date 1 year into the future may have a $3 premium per contract. A similar put contract with a $35 strike price might have a $6 premium per contract.
Good health or homeowners insurance can be expensive. The same can be true of buying puts to hedge against downside in your portfolio.
2. Building a Collar
One way you can reduce the cost of buying puts is by selling covered calls against your stock portfolio. This strategy is called a “collar,” and here’s how it works.
Say you have the same $40 stock mentioned before and you want to use options to hedge using a collar. The 1st step might be to buy puts with a $30 strike price for a $3 premium. If you then turn around and sell the same number of call options for the same stock with a strike price of $60, you might collect a premium of $1.50 on those contracts. By using a collar, you have cut the cost of your portfolio insurance in half.
The collar will still provide the same downside protection that a simple put buying strategy does, but it will also reduce the potential upside of your stock holding as well. In the example of the $40 stock, the call option buyer will exercise his option and buy your shares of stock if the share price rises above $60 before the expiration date of the contracts. In that scenario, you would be obligated to sell the call buyer your shares at $60, even if the market price of the stock rises to $65 or $70.
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