Unpacking These 5 Common Hedging Strategies

There's never a better time to discuss hedging strategies than after a sharp selloff from record highs. As we previously established, a hedge is an opposing position to an asset, which can reduce risk of adverse price movement. In other words, if a security does not move the way a trader had been hoping, he or she will still have the opposing position to fall back on.

There are a number of different strategies that can be used to hedge, including:

Protective Put

This strategy, which is also commonly known as a "married put," is used when a trader remains optimistic over the long-term prospects of a given company, but ultimately wants to protect against perceived risk of a decline, or short-term increased volatility. This can be accomplished by purchasing a put option, which then serves as an insurance policy on shares. To put it simply, the investor locks in a minimum selling price for the stock.

Protective Call

Conversely, a protective call is employed when cautious bears are betting on downside for an equity. However, in this scenario investors are trying to protect themselves against the risk of upside. They do so by buying a call option, which keeps at least a portion of their unrealized profits safe.

Covered Call

A covered call is more accurately described as a way to generate income on a stock that is not living up to short-term expectations. This means that the hedge is an asset a trader already owns. This strategy involves either selling or writing a call option against your own shares, so that this sale generates a premium payment for the seller right away.

Collar

A collar, which combines a protective put with a covered call, is a two-pronged strategy that locks profits and/or limits risks on a stock investment. The difference is that adding a covered call applies a credit toward the cost of the protective put, which either partially or completely offsets hedge costs. However, shares can be called away  when they breach the sold call strike prior to expiration.

Pairs Trade

Lastly, the pairs trade strategy involves separate bullish and bearish options plays on two different equities. This does not protect against losses in a stock in  the same way a protective put does. Rather, the idea here is to play a directional trading idea, while also shielding against unexpected headwinds in a certain industry, or even the overall market.