Options trading isn't just about leveraging stock returns—it's a powerful tool for hedging and managing portfolio risks. By strategically using options, investors can limit losses while maintaining upside potential. This guide explores key strategies for hedging stock portfolios with options.
Key Terminologies
Understanding options jargon is essential before trading. Here are the core terms:
Call Options
A call option grants the buyer the right (but not obligation) to purchase an asset at a predetermined price (strike price) within a set period. Buyers pay a premium for this right.
- Bullish strategy: Profits increase if the asset's price rises above the strike price.
Put Options
A put option allows the buyer to sell an asset at a specified strike price before expiration.
- Bearish strategy: Profitable when the asset’s price falls below the strike price.
Long vs. Short Positions
- Long (Buyer): Holds the contract, paying a premium for the right to exercise.
- Short (Seller): Sells the contract, collects the premium, and must fulfill the contract if exercised.
Strike Price
The pre-agreed price at which the asset is bought (call) or sold (put) if the option is exercised.
Premium
The price paid for the option, influenced by factors like volatility and time to expiration.
Exercising Options
- American options: Can be exercised anytime before expiration.
- European options: Only exercisable on the expiration date.
Expiration
Options expire on specific dates (e.g., third Friday of the month). Post-expiration, the contract becomes void if unexercised.
Options Data Sources
Backtest strategies using historical data and derivatives valuation tools. Reliable data platforms include:
👉 Comprehensive options analytics
Top Options Hedging Strategies
1. Protective Put (Married Put)
Objective: Shield long positions from downside risk.
- How it works: Buy puts on owned stocks. If prices drop, put gains offset stock losses.
- Example: Buy 100 shares at $50; purchase a $45-strike put for $2. If stock falls to $40, exercise the put to sell at $45, limiting loss to $7/share ($50 - $45 + $2 premium).
2. Covered Call
Objective: Generate income while capping upside.
- How it works: Sell call options on owned stocks. Earn premiums if the stock stays below the strike price.
- Example: Own 100 shares at $50; sell a $60-strike call for $1. If stock stays at $55, keep the $1 premium. If it rises to $65, sell shares at $60, capping profit at $10/share plus premium.
3. Collar Strategy
Objective: Zero-cost hedge by combining a protective put and covered call.
- How it works: Sell a call to fund a put purchase. Limits upside/downside.
- Example: Own stock at $50; sell a $60-strike call ($2 premium) and buy a $45-strike put ($1.50 premium). Net credit: $0.50.
4. Long Straddle/Strangle
Objective: Profit from high volatility.
- Straddle: Buy ATM call and put with same strike/expiration.
- Strangle: Buy OTM call and put with different strikes.
- Breakeven: Price must move beyond total premium paid.
5. Put Ratio Backspread
Objective: Hedge against steep declines.
- How it works: Sell one put, buy two lower-strike puts.
- Example: Sell $50-strike put ($2 premium); buy two $47-strike puts ($0.75 each). Net credit: $0.50. If stock drops to $43, profit offsets losses.
FAQs
Q: What’s the cheapest hedging strategy?
A: Collars (near zero-cost) by pairing covered calls with protective puts.
Q: How do I choose strike prices?
A: Balance risk/reward:
- Protective puts: ATM or slightly OTM for cost efficiency.
- Covered calls: OTM to retain upside.
Q: Can hedging eliminate all losses?
A: No, but it reduces downside risk. Always account for premiums and breakeven points.
Q: Where can I analyze options data?
Conclusion
Options hedging is a versatile way to protect and enhance portfolios. Start with simple strategies like protective puts or covered calls, then explore advanced tactics like collars and straddles. Always assess risk tolerance and market conditions before trading.
For deeper insights:
👉 Mastering options hedging