Using Options for Hedging

As well as being trading instruments, options can be powerful risk management tools for hedging and reducing portfolio volatility. Here are some specific examples of how investors can use options to protect their portfolios:

Protective Put Strategy

This is one of the most common hedging strategies using options. Example: An investor owns 100 shares of Apple (AAPL) stock, currently trading at $150 per share. To protect against potential losses, they buy a put option with a strike price of $140, expiring in 3 months, for a premium of $5 per share.

  • If AAPL drops to $120, the put option limits the loss to $15 per share ($150 – $140 + $5 premium), instead of $30 per share without the hedge.
  • The total cost of this protection is $500 (100 shares x $5 premium), which acts as an insurance policy against significant downside risk.

Collar Strategy

This strategy combines a protective put with a covered call to reduce the cost of hedging.Example: An investor holds 100 shares of Microsoft (MSFT) at $300 per share. They:

  1. Buy a put option with a strike price of $280 for $8 per share
  2. Simultaneously sell a call option with a strike price of $320 for $6 per share
  • The net cost of this hedge is only $2 per share ($8 – $6)
  • This strategy limits potential losses below $280 while capping gains above $320.

Index Put Options

Investors can use index options to hedge against broader market declines.Example: An investor with a diversified portfolio closely tracking the S&P 500 could buy put options on the S&P 500 index (SPX).

  • If the market declines, the gains from the put options would offset losses in the overall portfolio
  • This strategy provides protection against systemic market risk rather than stock-specific risk.

Long Put Calendar Spread

This strategy can be used to hedge against short-term volatility while maintaining long-term bullish outlook. Example: An investor expects short-term volatility in Tesla (TSLA) stock but remains bullish long-term. They could:

  1. Sell a near-term put option (e.g., expiring in 1 month)
  2. Buy a longer-term put option (e.g., expiring in 3 months) with the same strike price
  • This strategy provides short-term downside protection while allowing for potential long-term gains
  • The cost of the long-term put is partially offset by the premium received from selling the short-term put.

Reverse Collar

This strategy is useful for protecting unrealized gains in a stock position.Example: An investor has a large gain in Amazon (AMZN) stock, currently at $3,500 per share, with a cost basis of $2,000.

  1. Buy a put option with a strike price of $3,400
  2. Sell a call option with a strike price of $3,600
  • This locks in most of the gains while still allowing for some upside potential
  • The strategy is particularly useful when an investor can’t or doesn’t want to sell the stock due to tax implications or other reasons.

These strategies demonstrate how options can be used flexibly to hedge against various market risks, from protecting individual stock positions to safeguarding entire portfolios against broad market declines. The choice of strategy depends on the specific risks an investor faces, their market outlook, and their risk tolerance.