A few Cabot Options Trader subscribers have asked me about ways to protect gains in their portfolios, so I thought I would write to everyone with a couple of strategies for hedging a portfolio with options. When we have periods of high volatility it becomes more expensive to hedge by buying and simultaneously more profitable to hedge by selling.
Because I can’t possibly know what you have in your portfolio, I’ll base the strategies on a faux stock I’ll call STOCK with hypothetical option values.
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Let’s say STOCK is trading at 138.40. For this exercise, I’m going to assume that you own 1,000 shares of STOCK, which would be worth $138,400.
Here are a couple of different strategies you can use to start hedging a portfolio with options.
Covered Call
A covered call is a risk-reducing strategy; in this, 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” you entirely. If STOCK 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 1,000 shares of STOCK, and therefore you are able to sell 10 calls against your stock so that you are covered.
For this theoretical exercise, I will look a few months out, and 5% out of the money. Based on these criteria, you could sell October 145 calls for $3.40. If STOCK stayed below 145 by October expiration, you would collect $3,400, or a yield of 2.4%. If you did that twice a year, you would collect $6,800, or a yield of 4.8%.
You can choose any number of months or strikes. For instance, you could sell five October 145 calls and five January 150 calls. There are seemingly limitless amounts of calls you can sell, in many different combinations.
Put Purchase
Once again, assuming you own 1,000 shares of STOCK, the truest hedge would be to buy 10 puts against it. If STOCK were to drop below your puts strike price, you could simply exercise your puts, 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 STOCK price continues to rise.
For instance, you could buy 10 October 135 puts for $4.20. So if STOCK were to drop below 135, you would exercise your puts, and you would be taken out of your STOCK stock position. However, you have to pay $4.20, or $4,200, for this insurance.
Again, you can choose any number of strikes and time frames for this strategy.
Risk Reversal
This is a more sophisticated strategy but is a truer way to start hedging a portfolio with options 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 1,000 shares of STOCK, you could sell an October 145 call for $3.40 and buy the October 135 put for $4.20. In this case, your capital outlay is only $0.80, whereas, in the put purchase above, you were paying $4.20.
So let’s break down the various scenarios of this trade. If STOCK were to go below 135 by October, you could exercise your puts and get out of your stock position. On the other hand, if STOCK were to rally above 145, you would be taken out of your stock position by the holder of your short call. If STOCK were to stay between 135 and 145, the position would expire worthless and you would be out the $0.80 (or $80 per 100-share contract) that you paid for this position.
Conclusion
You can use any of these strategies against any of your equity or index holdings. If you own a lot of Boeing (BA) 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.
What else would you like to know about hedging a portfolio with options?
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*This article has been updated from an original version that was published in 2013 and is periodically updated to reflect market conditions.
