SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

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

Using Options To Hedge Investments


Options inherently have been met with much speculation, and anyone who trades them knows this. Many bankers and financial advisors steer clear of options because of their potential risk. Are they correct in doing so? I don't believe they are. Options when used correctly can provide better annual returns than a traditional buy and hold method.

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 with options 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.

 

Hedging with put options

 

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 you can hedge with a put option.

 

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.

 

hedge2.jpg

 

Hedging with call options

Hedging with call options 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 with options 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.

 

Conclusion

 

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 Stocktradesan 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.

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • A Global Equity Put Write Portfolio

    Many that sell equity market put options focus on the S&P 500 (SPX, XSP, SPY). Some will add small caps by selling puts on the Russell 2000 (RUT, IWM). An investor could also make their put selling strategy globally diversified by adding MSCI EAFE (EFA) and Emerging Markets (EEM).

    By Jesse,

    • 0 comments
    • 199 views
  • The Random Walk Hypothesis

    The “random walk hypothesis” (RWH) is one idea about how stock prices behave – but only one of many. It is a theory promoted in academia and believed in my many, but not so much by traders involved with handling real money. Theories aside, is the market truly random?

    By Michael C. Thomsett,

    • 0 comments
    • 279 views
  • How To Trade Options Successfully

    I’ve now been trading options for over a decade and been associated with Steady Options for seven years – hard to believe.  Over that period, I’ve learned quite a bit about option trading; how to improve, what not to do, and generally how the option markets work. I’m still learning.

    By cwelsh,

    • 3 comments
    • 525 views
  • January 2019 Performance Analysis

    No one likes losing money, and no one likes hearing "excuses". However, in an effort to be fully transparent, solicit feedback, and to improve our own performance, we're writing this article to do a further breakdown of the losses which our model portfolio incurred in January 2019. 

    By Kim,

    • 17 comments
    • 1,322 views
  • Island Clusters as Strong Reversals

    Options traders constantly seek the elusive reliable reversal signal. A few unusual but strong reversals are worth looking for, and their patterns reveal likely exceptional timing for opening or closing option trades. One example of this exceptionally strong signal is the island cluster (or, island reversal).

    By Michael C. Thomsett,

    • 0 comments
    • 357 views
  • What’s Wrong With Your 401(k)? (If anything)

    There currently are over sixty million Americans that are active 401(k) participants, and well over 500,000 total active 401(k) plans offered by employers in the United States.  Despite these high numbers, usages could be higher, as the US Census Bureau estimates that only 41% of all employees with access to a 401(k) plan utilize it, with even less funding it fully.

    By cwelsh,

    • 0 comments
    • 439 views
  • Upcoming Decay of Options

    I am on the hunt for a short volatility position for three main reasons. First, the market’s wild swings have, for the time being at least, diminished. Second, option activity has dried up as my options barometer continues to be stuck in the 4 – 6 range as traders are not making big bets in either direction.

    By Jacob Mintz,

    • 0 comments
    • 520 views
  • The Scientific Process of Increasing Expected Returns

    For many US investors, the "base case" for equity investing is US large cap stocks, most commonly benchmarked as the S&P 500. You could absolutely do far worse than owning these 500 great US companies, and the weight of the evidence suggests that most actively managed mutual funds that benchmark themselves against the S&P 500 index have in fact done worse.

    By Jesse,

    • 0 comments
    • 902 views
  • Those Golden and Death Crosses

    The use of moving average (MA) for predicting future price behavior must be undertaken cautiously. MA is a lagging indicator, so the question must be: Can a lagging indicator provide guidance for the future? Yes. The use of two MA lines and how they interact is a reliable form of reversal indicator.

    By Michael C. Thomsett,

    • 0 comments
    • 632 views
  • Trading Reverse Iron Condors When IV Is Elevated

    Our members know that pre earnings straddles and calendars have been our bread and butter strategies in the recent years. We enter those trades when the prices are cheap compared to previous cycles. However, in the last few months of 2018, Implied Volatility exploded, making most of those trades too expensive.

    By Kim,

    • 0 comments
    • 706 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