SteadyOptions is an options trading forum where you can find solutions from top options traders. Join Us!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

The Importance  of Proactive Hedging in Options Trading


Investing in the stock market can be a daunting task for even the most experienced investors. With the constant fluctuations and volatility of the market, it can be difficult to predict the future direction of the market. This is where options trading comes into play.

Options provide investors with the ability to proactively hedge their portfolios against potential market crashes. In this article, we will discuss the importance of being proactively hedged in an options portfolio.

 

Why to Hedge?

One of the most critical reasons why it is important to be proactively hedged in an options portfolio is that it is too late to hedge once a market crash has already started.

When a market crash occurs, the prices of stocks plummet, and investors suffer significant losses. The time to hedge your portfolio is before the crash occurs, not after. Proactive hedging involves taking steps to protect your portfolio before the market downturn occurs.

Proactive hedging involves purchasing options that will benefit from a market downturn. These options are typically put options, which give the holder the right to sell an underlying asset at a predetermined price.

When the market crashes, the value of these put options increases, offsetting the losses incurred in the underlying stock. Another reason why it is important to be proactively hedged in an options portfolio is that it can help reduce the overall risk of the portfolio.

By purchasing put options, investors are essentially buying insurance against potential market downturns. While the cost of these options can be significant, they can provide a significant return on investment if a market crash occurs. In essence, proactive hedging is a form of risk management that can help protect investors from significant losses.


Furthermore, proactive hedging can also help investors take advantage of market opportunities. When the market is in a downturn, there are often opportunities to purchase stocks at discounted prices. By hedging their portfolios, investors can protect themselves against losses while still having the capital available to take advantage of these opportunities.
 

The Collar

There is a well known technique used to be proactively hedged while looking to profit. This technique is called the "collar" strategy. 


This strategy involves simultaneously purchasing put options to protect against downside risk while selling call options to generate income. The income generated from selling the call options can be used to finance the purchase of the put options, effectively creating a "collar" around the portfolio.


A collar is a trading strategy that is commonly used to limit the potential loss of an underlying asset while also capping its potential profit. It is created by combining a long position in an asset with a protective put option and a short call option.

image.png


While a collar can be an effective way to protect an investor's position in the market, there are several weaknesses to this trade structure. Here are a few examples:

  1. Limited Profit Potential: One of the main weaknesses of a collar is that it limits the potential profit that an investor can make. By using a protective put option and a short call option, the investor is essentially giving up some of their potential gains in exchange for protection against losses. While this may be a smart move in certain market conditions, it can also be a hindrance in others.
     
  2. Costly to Implement: Another weakness of a collar is that it can be expensive to implement. This is because the investor must pay for both the protective put option and the short call option. Depending on the price of the underlying asset and the specific options being used, this cost can add up quickly.
     
  3. Requires Active Management: A collar also requires active management in order to be effective. This means that the investor must be constantly monitoring the market and their position in order to make informed decisions about when to adjust the collar. This can be time-consuming and stressful for some investors.
     

The Alternatives

The collar strategy, while well-known, has some weaknesses that can limit an investor's potential gains and require active management. However, there are lesser-known strategies that can achieve the goal of proactively hedging without these downsides. These advanced techniques involve combining ratio spreads with butterflies and relying on second-order Greeks. As a result, these strategies offer several advantages, including:
 

  1. Greater Flexibility: These advanced strategies are more flexible than the collar strategy, allowing for more nuanced adjustments to an investor's position in response to changing market conditions.
     
  2. Lower Cost: These strategies are less expensive to implement than the collar strategy, which can require the purchase of both a protective put option and a short call option.
     
  3. Potential for Higher Gains: By relying on second-order Greeks and combining ratio spreads with butterflies, these strategies have the potential for higher gains than the collar strategy.
     
  4. Reduced Need for Active Management: These advanced strategies can require less active management than the collar strategy, which can be a benefit for busy investors or those who prefer a more hands-off approach.

While the collar strategy has its place in certain market conditions, there are advanced options trading strategies that can offer several advantages over the collar strategy. These techniques are worth exploring for investors who are interested in proactively hedging their positions while also maximizing their potential gains.
 

Conclusion

In conclusion, investing in the stock market can be risky and unpredictable, but options trading can provide a way to proactively hedge against potential market crashes.

Being proactively hedged involves taking steps to protect your portfolio before a market downturn occurs. The collar strategy is a well-known technique used for proactively hedging, but it has some weaknesses that can limit an investor's potential gains and require active management. However, there are advanced options trading strategies that can offer greater flexibility, lower cost, potential for higher gains, and reduced need for active management.

Ultimately, investors should  consider all options trading strategies to find the one that best suits their risk tolerance, investment goals, and market conditions. By proactively hedging their portfolios, investors can reduce their risk exposure, take advantage of market opportunities, and potentially achieve higher returns.



About the Author: Karl Domm's 29+ years in options trading showcases his ability to trade for a living with a proven track record. His journey began as a retail trader, and after struggling for 23 years, he finally achieved 
consistent profitability in 2017 through his own options-only portfolio using quantitative trading strategies.

After he built a proven trading track record, he accepted outside investors. His book, "A Portfolio for All Markets," focuses on option portfolio investing. He earned a BS Degree from Fresno State and currently resides in Clovis, California. You can follow him on YouTube and visit his website real-pl for more insights.

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Real-time trade sharing: entry, exit, and adjustments

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Subscribe to SteadyOptions now and experience the full power of options trading!
Subscribe

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • SPX Options vs. SPY Options: Which Should I Trade?

    Trading options on the S&P 500 is a popular way to make money on the index. There are several ways traders use this index, but two of the most popular are to trade options on SPX or SPY. One key difference between the two is that SPX options are based on the index, while SPY options are based on an exchange-traded fund (ETF) that tracks the index.

    By Mark Wolfinger,

    • 0 comments
    • 449 views
  • Yes, We Are Playing Not to Lose!

    There are many trading quotes from different traders/investors, but this one is one of my favorites: “In trading/investing it's not about how much you make, but how much you don't lose" - Bernard Baruch. At SteadyOptions, this has been one of our major goals in the last 12 years.

    By Kim,

    • 0 comments
    • 898 views
  • The Impact of Implied Volatility (IV) on Popular Options Trades

    You’ll often read that a given option trade is either vega positive (meaning that IV rising will help it and IV falling will hurt it) or vega negative (meaning IV falling will help and IV rising will hurt).   However, in fact many popular options spreads can be either vega positive or vega negative depending where where the stock price is relative to the spread strikes.  

    By Yowster,

    • 0 comments
    • 799 views
  • Please Follow Me Inside The Insiders

    The greatest joy in investing in options is when you are right on direction. It’s really hard to beat any return that is based on a correct options bet on the direction of a stock, which is why we spend much of our time poring over charts, historical analysis, Elliot waves, RSI and what not.

    By TrustyJules,

    • 0 comments
    • 479 views
  • Trading Earnings With Ratio Spread

    A 1x2 ratio spread with call options is created by selling one lower-strike call and buying two higher-strike calls. This strategy can be established for either a net credit or for a net debit, depending on the time to expiration, the percentage distance between the strike prices and the level of volatility.

    By TrustyJules,

    • 0 comments
    • 1,490 views
  • SteadyOptions 2023 - Year In Review

    2023 marks our 12th year as a public trading service. We closed 192 winners out of 282 trades (68.1% winning ratio). Our model portfolio produced 112.2% compounded gain on the whole account based on 10% allocation per trade. We had only one losing month and one essentially breakeven in 2023. 

    By Kim,

    • 0 comments
    • 5,902 views
  • Call And Put Backspreads Options Strategies

    A backspread is very bullish or very bearish strategy used to trade direction; ie a trader is betting that a stock will move quickly in one direction. Call Backspreads are used for trading up moves; put backspreads for down moves.

    By Chris Young,

    • 0 comments
    • 9,497 views
  • Long Put Option Strategy

    A long put option strategy is the purchase of a put option in the expectation of the underlying stock falling. It is Delta negative, Vega positive and Theta negative strategy. A long put is a single-leg, risk-defined, bearish options strategy. Buying a put option is a levered alternative to selling shares of stock short.

    By Chris Young,

    • 0 comments
    • 11,147 views
  • Long Call Option Strategy

    A long call option strategy is the purchase of a call option in the expectation of the underlying stock rising. It is Delta positive, Vega positive and Theta negative strategy. A long call is a single-leg, risk-defined, bullish options strategy. Buying a call option is a levered alternative to buying shares of stock.

    By Chris Young,

    • 0 comments
    • 11,528 views
  • What Is Delta Hedging?

    Delta hedging is an investing strategy that combines the purchase or sale of an option as well as an offsetting transaction in the underlying asset to reduce the risk of a directional move in the price of the option. When a position is delta-neutral, it will not rise or fall in value when the value of the underlying asset stays within certain bounds. 

    By Kim,

    • 0 comments
    • 9,671 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs