Three Simple Options Strategies to Hedge Your Portfolio

Three Simple Strategies

Covered Call, Put Purchase, Risk Reversal

Using Options to Hedge Your Portfolio

Three Simple Strategies

Paul Goodwin, the Emerging Markets Specialist and Chief Analyst of Cabot China & Emerging Markets Report, wrote a great article this week explaining market psychology and what is happening in Greece and China and how it may be affecting our market. Here is a brief excerpt of what he wrote:

“Markets are used to all kinds of stressful events, and for the past year or so have taken the Greek debt crisis pretty much in stride. But as good as markets are at rational discounting in the face of a crisis, they are definitely not good at handling two crises at once. So when the Chinese stock market began to implode last week—the result of a year of speculative buying by Chinese investors and the government’s unexpected tightening of margin requirements—the result was extreme. Like a man under attack from a pit bull at his ankles and a swarm of bees around his head, a bit of panic was understandable.” (You can find Paul’s commentary here)

This panic that Paul wrote about sparked a greater than 2% decline in the markets on Monday. So how do you protect your portfolio from a pit bull and a swarm of bees?

There are several options strategies that you can implement to hedge your portfolio. Because I can’t possibly know what you have in your portfolio, I’ll base the strategies on the SPDR S&P 500 ETF (SPY), which corresponds to the price and yield performance of the S&P 500 Index.

(Note: You may not be allowed to hedge your mutual fund holdings by trading the SPY. For instance, if you own mutual fund XYZ, your broker may not allow you to sell calls in the SPY because they don’t move in exact correlation. But that is a conversation you should have with your brokerage provider.)

The SPY is trading at 207 this morning. For this exercise, I’m going to assume that you own 100 shares of SPY, which is currently worth $20,700.

Covered Call, Put Purchase, and Risk Reversal

Here are three strategies you can use to “hedge” your portfolio. (Please note: The market is incredibly volatile these days, so the prices I use as examples below could be outdated in a matter of minutes or hours.)

Covered Call

A covered call is a risk-reducing strategy; for which a call option is written (sold) against an existing stock position on a share-for-share basis. The call is said to be “covered” by the underlying stock, which could be delivered if the call option is exercised.

This is a great way to create yield in your portfolio, though I will say it does not “hedge” your stock entirely. If the SPY were to drop dramatically, you would collect the premium taken in, but you would still be long the stock.

So based on our example, you own 100 shares of the SPY, and therefore you are able to sell one calls against your stock so that you are covered.

For this theoretical exercise, I will look four months out, and 3% out of the money. Based on this criteria, you could sell the September 213 calls for $2.50. If the SPY stays below 213 by September expiration, you would collect $250, or a yield of 1.22%. If you do that twice a year, you would collect $500, or a yield of 2.44%. Plus, if the stock rallies, you will make $100 for every dollar the stock rallies up to 213. At 213, you may be taken out of your stock and option position.

You can choose any number of months or strikes. For instance, you can sell September 213 Calls or December 215 Calls. There are nearly limitless amounts of calls you can sell in many different combinations.

This is a profit and loss graph of your covered call position.

Put Purchase

Once again assuming you own 100 shares of the SPY, the truest hedge would be to buy one put against it. If the SPY were to drop below your put’s strike price, you could simply exercise your put, and you would be out of your entire stock position. The upside to this strategy is that you do not cap the potential profit if the SPY price continues to rise.

For instance, you could buy one September 204 put for $5.00. So if the SPY were to drop below 204, you would exercise your put, and be taken out of your SPY stock position and your losses would stop. However, you have to pay $5.00 (or $500 in this example), for this insurance. But with the VIX at historically low levels, this insurance is extremely cheap based on historical prices.

Again, you can choose any number of strikes and timeframes for this strategy.

This is a profit and loss graph of your put purchase position.

Risk Reversal

This is a more sophisticated strategy, but is a truer hedge to your portfolio than a covered call. You must be able to trade spreads in order to execute a Risk Reversal.

In this example, you will be selling a call that is out-of-the-money and buying a put that is out-of-the-money. This is a strategy that will reduce the capital that you have to pay for your hedge, but it limits your upside.

Once again, assuming you own 100 shares of the SPY, you could sell September 213 Calls for $2.50 and buy September 204 Puts for $5.00. In this case, your capital outlay is only $250 ($500 to buy the put, but you receive $250 for selling the call), whereas in the straight put purchase above, you were paying $500.

So let’s break down the various scenarios of this trade. If the SPY were to go below 204, you could exercise your puts and get out of your stock position and stop any losses. On the other hand, if the SPY were to rally above 213, you would be taken out of your stock position by the holder of your short call, and thus your upside is capped. If the SPY were to stay between 204 and 213, the position would expire worthless and you would be out the $250 that you paid for this hedge.

This is a profit and loss graph of your risk reversal position.

Conclusion

You can use any of these strategies against any of your optionable equity or index holdings. If you own a lot of Apple (AAPL) or General Electric (GE) stock for instance, you can hedge your stock positions with these strategies.

If you want to hedge your mutual fund holdings, talk to your brokerage provider to see how you can implement strategies like these.

Your guide to successful options trading,

Jacob Mintz

Chief Analyst, Cabot Options Trader (Basic and Pro)

P.S.
At Cabot Options Trader, I offer a complete options education, and only recommend trades in which the odds are clearly in our favor. When I buy options, I risk pennies to make dollars. When I sell options, I never expose my subscribers to any catastrophic risks. Sometimes I go for singles; other times I’ll try to hit home runs. My options trading strategies are varied enough to cater to all investors depending on their investment objectives, risk tolerance and available assets.

With a little education, options trading can be simple, low-risk, fun and most importantly, profitable.

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