Unpredictable market swings stressing you out? These three strategies for using options to hedge will minimize your downside risk while protecting your portfolio.
Have you been anxious about your portfolio ever since the market became a COVID-19 rollercoaster?
Despite the giant tumbles and record-lows of coronavirus investing, it’s crucial to stick to your financial plan during these unpredictable times if you want to maximize your investments.
But you may also consider using options to hedge your portfolio and minimize the damage a volatile market may inflict upon your assets.
What is Portfolio Hedging?
A hedge is a strategy designed to protect your investments by mitigating or reducing risk. Here, risk is considered anything that may cause your assets to suddenly decline in value.
Portfolio hedging gives you the ability to offset potential losses that may result after a market crash, interest rate hike, inflation, and more. It provides a bit of stability to ease uncertainty.
Bottom line: Hedging safeguards your portfolio from crazy price movements to shield you from the worst losses.
The most common and effective long-term hedging technique is diversification.
Diversify to Hedge Your Portfolio Long-Term
Diversification is the best way to protect your portfolio from the market’s predictable unpredictability.
When your portfolio contains different types of assets, you spread around your risk and don’t put all your eggs in one basket. So your portfolio should contain a mix of stocks as well as real estate, commodities, bonds, currencies, etc.
You should also diversify when it comes to stocks.
During coronavirus quarantine, for example, oil plummeted while work-from-home tech like Slack soared. A well-diversified portfolio would have been able to offset the energy loss with the tech gains.
Holding unrelated assets reduces your portfolio’s overall volatility and somewhat stabilizes returns. But this isn’t your only hedging strategy.
You can also use options to hedge your portfolio.
What are Options in Stocks?
A stock option gives you the right, but not the obligation, to buy or sell shares at an agreed-upon price (known as the strike price) before a predetermined date (known as an expiration date).
There are two types of options:
- Calls give you the right to buy stock at the strike price before the expiration date
- Puts give you the right to sell stock at the strike price before the expiration date
Your strike price reflects the price point you’ll be comfortable buying/selling stocks. And each contract represents the buying/selling of 100 shares of underlying stock.
Let’s discuss the ins and outs of how to use options next.
Using Options to Hedge: 3 Strategies
Although everyone’s main goal with investing is to keep earning profits, these three proactive options strategies may help protect your portfolio from unforeseen market declines:
#1. Buy Puts
What strategy could be considered insurance for an investment in a portfolio of stocks?
Buying put options.
When you buy a put, you’re essentially paying a premium to shield your portfolio from the effect of a major decline in a stock..
So let’s say you’re holding a stock trading at $20/share. You can pay a small premium to buy a put with a strike price of $15.
If your stock drops in value to $8/share before the expiration date, you have the option to sell it at your strike price ($15). So rather than taking a loss of $12/share, you’ll only lose $6/share, or half that amount. Multiply this times 100 shares in a contract, and the money really adds up.
In the end, you’re still taking a loss, but the damage is much less than it could be. Or, if you purchased the stock at say $14/share, and it ran up to $20/share before declining to $8/share, you would still have made money by selling it at the strike price.
Buying a put option may protect you from catastrophic freefalls in share price/prior gains. It lends a bit of certainty to your portfolio because you know your shares won’t fall below your strike price, which should be tied to your level of risk.
If your stock never dips below the strike price before the expiration, you won’t lose any value in your shares, but you will lose the premium you doled out to buy the put.
You can also purchase puts on a market index such as the S&P 500. This is analogous to buying a homeowner’s insurance policy to protect your home against losses from a hurricane or fire. The cost of the put is what you pay to protect against a big market loss, which is why these puts are referred to as “protective puts”.
If there is no big market decline, you lose the entire premium on the cost of the put, but never more than that. You only make money on the put if the market index drops below the put’s strike price. So, much like you don’t want the hurricane to hit your house so you can make money, you don’t want a drop in the market so that you can get a payoff from these protective put positions. But they can certainly help financially cushion against a big decline.
The cost of a protective put on the whole equity portion of your portfolio is 1-3% of the total return, so it is not a good tool for long-term investing. However, if you are especially nervous, using this tool can keep you in the market so that you don’t have to sell out of positions that may have large gains and big tax consequences. There is also the added benefit that you then won’t have to try to time exactly when to get back into the market, hence missing a quick market recovery.
The bottom line: If you are nervous and considering selling your equites to hold cash, consider this alternative strategy for a six-month or one-year period until you feel confident in the market to stop holding puts. It’s not recommended to hold puts for the long term, the reoccurring costs are a drag on your long-term returns. If you have a long-term investment horizon, you should just stay in the market to optimize your returns.
#2. Sell a Covered Call
While selling a covered call is generally used to enhance earnings and boost your portfolio, you can also use this strategy to guard yourself from significant losses.
As you may recall, a call option lets you pay a premium to gain the right to buy 100 shares of a stock at your strike price until the expiration date.
But you can also sell a call option and earn the option premium in addition to the appreciation of the stock itself.
In this case, an option buyer will purchase the call from you at your strike price and give you the premium money as upfront cash.
So let’s say you sell a call with a strike price of $50/share and an expiration date of six months. Your buyer may pay a $10 premium per share, resulting in a profit of $1,000 in premiums alone.
Selling calls is a quick way to generate income and offset losses elsewhere in your portfolio. And it’s most profitable when premiums are ultra-high, which they currently are.
You need to be aware that if the buyer exercises the option, you are required to sell the underlying stock to that buyer. If you don’t really want to sell the underlying stock (because you are just interested in earning the option premium), you can close out the option prior to it hitting the strike price. But this requires diligent monitoring.
#3. Build Collars
Collars are the most popular options strategy for protecting the value of your portfolio from the market’s ups and downs. However, they limit both your losses and your gains.
To initiate a collar, you’ll need to perform a combination of the first two strategies already described:
- Buy one put option, giving you the right to sell 100 shares of stock
- Sell one call option, giving someone else the right to buy those same shares
With this strategy, you’ll pay cash for the put option at the same time you’ll collect money for selling the call. This should balance out so you can minimize losses without investing any additional out-of-pocket money.
To put this in perspective, let’s say you have stock that just hit $100/share.
You’re not sure how stable this price will remain, but you want to know how to lock in stock gains without selling.
So you employ a two-part collar strategy:
- You buy a put option with a strike price of $90 at a premium of $5.
- You sell a call option for $5 with a strike price of $110.
If your assets fall to $80/share:
- Your underlying assets ultimately lose value (for a $20 loss)
- But your put option will stave off the worst of your losses (only incurring a $10 drop)
- A buyer will not exercise the call option you sold; you still receive the $5 for selling
In this scenario, a $20 loss becomes a $10 dip.
Now, if your asset hits $105:
- You’ll earn a gain of $5/share
- But your put option will not be exercised, so you’ll lose your $5 premium
- And your call option won’t be used either, so you’ll keep the $5 payoff
In this example, you’d earn $5 on the appreciated stock, while the option premiums would be offsetting.
But what happens if the price of your asset increases higher than your strike price?
- Your underlying asset will be worth more (for a gain in profit)
- Your put option will not be exercised, meaning you’ll lose the $5 premium
- The call option will be exercised at your strike price, earning you nothing
So utilizing a collar may limit the earning potential of your underlying asset. But the put and call costs cancel each other out (known as a zero-cost collar) to mitigate your risks.
Let’s Talk About Hedging Stock Options Together
Every portfolio is vulnerable to market risks. So if you’re worried about your investments amidst the market volatility of COVID-19, it may be time to speak with your financial advisor about all your options.
The right partner will help you create, navigate, and protect your portfolio for today’s demands and your future goals.
While a well-diversified portfolio is the best defense against wild market swings, an experienced financial advisor can help you decide if these three options strategies might work for you.
Get in touch with one of our Castle Wealth Management experts now, and protect what you’ve built and gained so far.