4 Ways to Protect Your Portfolio

Protective puts, pairs trades, collars, and the stock repair strategy are four ways options can be used to hedge

by Karee Venema

    Published on Jan 21, 2016 at 2:44 PM
    Updated on Jun 24, 2020 at 10:16 AM

    It's been a roller-coaster ride for investors this year, with most of the action occurring to the downside. Last Friday, for example, the Dow was down 537 points at its intraday low, and yesterday, the blue-chip barometer fell more than 560 points before paring these losses to 249 points. Helping to stoke the bearish flames have been a steep sell-off in oil, a lackluster start to fourth-quarter earnings season, and uncertainty over the Fed's next move.

    While it would seem all hope is lost for the average investor in such a skittish environment, the options market allows traders different ways to guard their portfolio against the elements, including protective puts, pairs trades, collars, and the stock repair strategy. Keep reading to learn more about these four hedging strategies.

    Protective Put

    In its most basic form, a put option is bought when a speculator has a bearish view on the market, but wants more limited risk than a short seller. By purchasing a put, the trader gains the right to sell 100 shares of the stock at the strike price, should the security fall below the strike by expiration. Simply stated, puts will profit with each step below the selected strike the underlying takes over the life span of the option.

    As a hedging vehicle, a shareholder can employ a protective, or "married," put to guard against losses to their portfolio. For instance, if a trader is optimistic about a stock in her portfolio, but the market environment is extremely volatile and/or the company's earnings announcement is looming on the horizon, she can buy to open an out-of-the-money (OOTM) put. This gives her the right to sell her stock at a level she's comfortable with in the event of a drop -- and possibly gain a profit off the sale of her long put. Conversely, should the equity continue its ascent, she'll simply surrender the initial premium paid to buy the put, and watch her portfolio grow.

    Pairs Trades

    As its name implies, a pairs trade is a two-pronged strategy used by a speculator with a more neutral outlook. In other words, this trader may be bullish on a certain equity, but nervous about the overriding sector or broader market. To implement the pairs trade, he may buy a call on the security he's optimistic about, while simultaneously buying a put on the sector that stock resides in. This allows the speculator to "cover his bases," and profit from a move in either direction. In the best-case scenario, the stock will rise, while the broader sector lags, and the trader can collect gains on both the call and the put.

    Collars

    Similar to a protective put, a collar is a strategy used by a shareholder to limit downside risk to her portfolio. A collar, however, lowers the cost of playing a protective put by combining it with a covered call. By saving a little cash on the cost of entry, though, the speculator has raised her risk. Specifically, should the security rally above the strike of the short call, her shares may be called away. In other words, she must choose a strike price at which she is comfortable unloading her shares.

    Stock Repair Strategy

    The stock repair strategy is used by shareholders who have had a security in their portfolio suffer substantial losses. In order to try and recover from the loss at no cost, the trader would implement a call ratio spread by buying to open enough at-the-money calls to cover the number of shares in his portfolio, while simultaneously selling to open two out-of-the-money calls for each one bought. The cost of the long calls will ultimately be offset with the credit collected by the short calls. While the stock repair strategy does not protect the shareholder from additional losses in the equity, it can lower his breakeven point.

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