2 Ways for Nervous Investors to Hedge with Options

A protective put can lock in a sale price for a stock you own, should it take a turn for the worse

Managing Editor
Dec 8, 2017 at 2:04 PM
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    It's been a crazy couple of weeks for the stock market, amid concerns about tax reform, tech stocks, and a government shutdown. Meanwhile, next week will bring us the launch of bitcoin futures and a possible Fed rate hike. While Schaeffer's Senior V.P. of Research Todd Salamone suggests traders "continue to use call options to participate in the record-breaking equity rally," below are a couple of ways nervous investors can hedge their bets with options. 

    Protective Put

    A protective put is purchased on shares you already own, typically at an out-of-the-money strike. The protective put acts as "insurance" in the event of a severe pullback on the stock.

    Specifically, if the underlying equity tanks and breaches the put strike within the option's lifetime, the shareholder can sell the stock at locked-in price (the strike) for more than what he or she would receive on the market. However, this is not to suggest protective put buyers don't want to see their stock rally; the puts are bought as a source of security to limit his or her losses in the event of a worst-case scenario. 

    Collar

    Another hedging technique for tepid investors is called a collar. A collar is simply a protective put partially or fully paid for by a covered call. Because of the sold call -- typically written at an out-of-the-money strike -- the collar is a riskier method of "insurance" for a stock you own.

    A collar is riskier than a lone protective put because the shares could be called away on a rally above the sold call strike. Therefore, if the stock is one the trader definitely wants to keep, he or she should consider following through with only a protective put, particularly during times when the underlying's options are attractively priced.

     

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