How to Hedge Your Bets With Put Options

How to use put options as a hedging tool when trading stocks and options

Mark Fightmaster
Aug 20, 2015 at 12:53 PM
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Options can be employed for a variety of reasons, not just to place directional bets. In fact, many traders utilize these relatively low-cost vehicles as "insurance" on their investments. Let's take a look at the many ways you can use put options to lower your risk.

Stock Protection 

Let's say you own 1,000 shares of Stock XYZ, which has doubled in value over the past few months, and is now trading at $110. While you remain bullish and want to keep the stock, you're concerned about a potential pullback over the next couple of months, and would like to lock in an acceptable price – say, $100 -- to hit the exits, if necessary.

To do so, you could purchase (to open) back-month put options at the 100 strike, which we'll say are being asked at $12 apiece. Since you own 1,000 shares of XYZ, and since each option represents 100 shares, you'd need to purchase 10 protective puts to "insure" your entire position.

Should XYZ take a turn for the worse and fall back into double-digit territory, the puts will move into the money. You can then exercise your option to unload the equity at the strike price -- $100 a share -- which represents a premium to what you'd get on the Street. Should XYZ resume its uptrend, on the other hand, you're out the cost of the puts, but you get to enjoy XYZ's extended rally -- and, as with any insurance policy, at least you had some peace of mind.

Portfolio Protection

Moving on, let's assume you're optimistic about the housing sector, which has been a broad-market standout in 2015. As such, you own several stocks under the housing umbrella. However, while you remain long-term bullish on the group, you're worried about the potential impact of central-bank moves or overseas markets.

Purchasing protective puts on each individual housing stock in your portfolio might be a bit much. But, buying puts on a corresponding exchange-traded fund (ETF) -- say, the iShares Dow Jones U.S. Home Construction Index Fund (ITB) -- could set your mind at ease amid any sector speed bumps. More specifically, you'd buy (to open) one put per 100 shares you'd like to protect.

Meanwhile, if you're concerned about potential broader turmoil, you could hedge against market weakness by purchasing puts on something like the SPDR S&P 500 ETF (SPY) or the Diamonds Trust (DIA), which are based on the movements of the -- you guessed it -- S&P 500 Index (SPX) and Dow Jones Industrial Average (DJIA), respectively.

It's worth noting, though, that since you probably don't own direct shares of the ETF you choose, it's unlikely you'll exercise your option. Instead, if your put moves into the money, you can sell it (to close) for a profit before expiration.

Reduce Your Options Risk 

Puts can also be utilized to trim your risk on a directional option play. In other words, you could use puts to hedge other puts, if you want.

For example, let's say you're bearish on Stock ZYX, which is lingering near $50 ahead of the company's earnings report next week. Since options demand -- and, thus, prices -- tends to increase ahead of a big event like earnings, you're hesitant to buy a "vanilla" 48-strike put at inflated levels.

To reduce the cost of the play -- which represents the maximum risk -- you could simultaneously sell the 44-strike put, initiating a bear put spread. By doing so, however, you also limit your maximum potential profit on the play (to the difference between strikes, minus the net debit).

In Conclusion 

There are a number of ways to use put options to your advantage. Like home or car insurance, puts can be purchased as protection for a stock or general portfolio -- and while you don't want disaster to strike, you can sleep better at night knowing your risk is limited. In the same vein, even directional option bets can be hedged with puts, as selling these options can help cushion the blow of relatively pricey premiums.


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