In fact, options combined with the traditional buy and hold method can produce excellent returns, and it is about time investors who are not in the know, learn how to use them. I question, will you make more in a trade by hedging? The answer is no, but you won't lose as much on the investments you are wrong about. An investor who knows how to use options to hedge investments is an investor who has an edge on ones that are too ignorant, or just can't cleanse themselves of the current negative stigma that options have.
So what exactly is a hedge?
Hedging is essentially reducing risk. You are entering a position that offsets your current investment, protecting you from potential drastic price movements. We hedge all the time in our everyday lives. When you purchase a brand new vehicle, you're not going to drive it on the highway without auto insurance. Lets forget about the legality of driving without insurance and just think about you potentially exposing your money, or the cost of the vehicle, to a drastic change such as a potential accident. When you purchase auto insurance, you are hedging against an accident. You may drive for 50 years without a single insurance claim, but at least you were covered if the worst were to happen.
How can I hedge with options?
Many options skeptics believe that with careful research and fundamental analysis there should be no reason to hedge a stock with an options contract. If you don't know about the “dot com bubble” of the early 2000's, I highly encourage you to Google it. It is fairly safe to say that although there was an abundance of ill-informed people investing at that time, there were some that did their homework and still lost. These investors could have saved their portfolios had they hedged their investments.
Lets go over some ways you can use puts and calls to hedge. For simplicities sake, during these examples we will not be including the premium it costs to buy these options. The premium paid is not a static number and the price paid depends on how comfortable the investor is with the underlying security.
Using put options to hedge
Lets say you're currently bullish on stocks in the oil and gas industry. You are long 100 shares of IMO(Imperial Oil) at $44.75 and although you are still comfortable owning them, you believe with the way the industry is going you need to protect yourself from a potential downfall. The easiest way to do this is to simply purchase a put option. As you probably already know, a put option gives you the right but not the obligation to sell 100 shares of the specific underlying security at the strike price. Lets go over a couple examples and explain how a put option can help you hedge.
Scenario 1: You decide not to hedge against a potential decline of Imperial Oil and the stock drops to 30 dollars over the next couple months. Fearing an even bigger decline, you decide to sell your stocks and you suffer a $14.75 loss per share, or $1475 total.
Scenario 2: You decide to hedge against the downfall, and purchase a put on IMO. You purchase a put that expires 6 months from now, with a strike price of 38. You now don't have to worry about a potential decline to 30 dollars a share, because your put gives you the right to sell your shares at any time within the next 6 months if the stock falls below 38. Lets say at expiration the stock sits at 30 dollars. You exercise your option and sell your shares at $38, eight dollars over market value, collecting $3800. Your loss is now $675 ($4475 - $3800), less the premium paid. This is less than half the amount you would have lost if you had decided not to hedge.
Using call options to hedge
Using call options to hedge is not as popular as puts. The reason being that this is when you hedge with a call, it means you are short the position. A lot of investors are not comfortable with short sales or do not have the ability to short depending on their account types. Lets go over a situation where you could hedge your short sale to prevent large losses. Please note that the extra costs involved with short selling such as interest are not considered.
You're currently bearish on stocks in the oil and gas industry. You believe that with the fall of oil, industry margins will decline and profits will decrease. You decide this is a good time to short 100 shares of IMO at $44.75 a share. You borrow the shares from your broker, sell them and your account is credited $4475.
Situation 1: You decide not to hedge your short, and over the next couple months IMO heads to $55 a share. You are worried the stock will go even higher and are forced to purchase the shares to give back to your broker. You end up paying $5500 dollars for these shares and suffer a $1025 loss.
Situation 2: You decide to hedge against an upward swing of the stock and purchase a call option on IMO. You are comfortable with paying $2.25 more on your shares if IMO takes a turn in the wrong direction and purchase a call with a $47 strike price. IMO sits at $55 dollars at expiration. Instead of buying the shares from the open market, you simply exercise your option to purchase the shares at $47 and close the short position with your broker. Your total loss in this situation is $225 dollars. The hedge saved this investor $800 less the premium paid.
The cost to hedge
Remember that when you are purchasing an options contract, it comes with a premium. If your car is worth $500 dollars, it probably doesn't make sense to pay an extra $70 dollars a month for collision insurance does it? You have to find a balance between the premium you're paying for your options and the level of protection you have.This ensures that when your option expires useless, you weren't paying a fortune to hedge. Keep in mind that options are a time wasting asset. The longer your expiration date is away, the more time premium you will pay. An option that expires in a year has much more value than an option that expires in a month. Hedging more often than not will include long-term options, so you will be paying a higher premium. Make sure you calculate these premium costs and make sure you aren't paying a fortune for your insurance.
Options are one of the most versatile investment vehicles you can use. Hedging with options is a crucial strategy that every buy and hold investor should have in his toolkit. The stock market is filled with surprises, and not hedging against them is exposing you to potential risk. An investor that is so confident with his investments that he doesn't feel the need to hedge them will soon be hit with a hard dose of reality. Does hedging make sense with every investment? Of course not! A day trader who expects to make small amounts of profit over a large amount of trades may not find it appealing to hedge his investments. But for most, hedging can be beneficial, and be reminded that greed and lack of knowledge are two of the various reasons investors go broke. Don't risk a large chunk of your portfolio just due to you didn't want to pay a small premium to protect yourself.
This is a guest post by Stocktrades, an investing website focusing on teaching new and intermediate investors the intricacies of the market. Learn how to trade options by following Dan's options blog. You can also follow them on Twitter StockTrades_CA.