Often times, investors find themselves in precarious situations when it comes to the stock market. It impacts all kinds of investors too. Short-term, long-term, those searching for income, those screening for day trades and the ones looking for multi-week or multi-month swing trades.
It’s the beauty of the markets; investors of all shapes, sizes and strategies are welcome to play. While all these strategies differ, they have one thing in common: downside.
The one drawback to any investment is the risk. Too much risk and investors eventually get punished. Too little risk and the returns may not even beat inflation, however paltry it is. And while there is no fool-proof way to evaporate that risk, there are ways to minimize it.
By isolating risk and minimizing its impact on one’s portfolio, they can concentrate on maximizing their reward. In investing, it’s all about minimizing downside and maximizing upside.
Using options is not only practical, but flexible too. While it may be hard to apply options in every scenario, they most certainly can be applied to a number of different investing techniques, helping out both traders and investors.
Let’s look at a few options (no pun intended) for hedging your portfolio.
Dan is a short-term trader. He buys individual stocks and looks for them to rally over the next few weeks. However, Dan is growing less confident in the overall market
While he could simply exit his position and wait for a more favorable environment, he could also consider using options to limit his downside. For instance, Dan could sell upside calls on his long position. While the short calls limit his upside after a modest rally in the stock, it also protects him if it trades flat or even slightly lower.
Take this trade for example:
With shares of Twitter (TWTR) trading at $18, Dan could sell the $19 call option for $1.40 that expires in the first week of December. Given that it’s late-October, that gives Dan about 6 weeks until expiration.
Dan collects the credit of $1.40 per share, which immediately lowers his cost basis by the same amount, $1.40. Assuming he bought the stock around $18, he now has an effective cost basis of $16.60. Of course, Dan’s upside is limited at $19 per share. But in a situation where his confidence is waning a bit, it may be worth trading some of the potential upside in order to minimize the downside.
Of course, the covered call strategy only provides so much protection. While, the stock could fall almost 8% from current levels and Dan wouldn’t experience a loss, a drop below $16.60 would be a different a story. His position would decline step-for-step with the stock price.
In order to protect against such an event, Dan could consider an enhancement to that strategy. For instance, using the $1.40 credit he received by selling the $19 call, Dan could also purchase the $17/$16 put spread for $0.45, and he would be left with a $0.95 credit.
It would look like this:
Buy 100 shares of Twitter at $18.
Sell the Dec. 2nd $19 call option for a $1.40 credit.
Buy the Dec. 2nd $17/$16 put spread for a $0.45 debit.
The $1.40 credit received minus the $0.45 debit paid, leaves Dan with a net credit of $0.95. This lowers his cost basis to $17.05.
Technically speaking, Dan’s maximum loss is $17.05 per share. Should the stock not fall below $16 before expiration, his maximum loss is just $0.05 per share, while his maximum upside is $1.95 per share, with his gains capped when the stock climbs above $19.
While the strategy is clearly more complicated, Dan has effectively reduced his risk-reward to a far more favorable position. So long as the stock does not endure an 11% decline, Dan’s worst-case scenario is a 5 cent-per-share loss, with a best-case scenario locking in almost $2 per share in gains.
What About the All-Around Portfolio?
Sometimes, investors aren’t looking for a swing trade. Instead, they may be looking for protection on their entire portfolio. This is a trickier situation, but one that can still be navigated.
In this scenario, Cheryl has a $100,000 portfolio, comprised of a simple 60-40 stock-bond mix. She could consider selling some of her equity positions and holding cash to reduce her risk.
However, she could also consider using options. For simplicity, let’s say Cheryl has a portfolio beta of 1.0, meaning it moves in lockstep with the S&P 500.
Cheryl could always consider buying put options or bear put spreads on market-based ETFs, such as the S&P 500 ETF (SPY) or the Russell 2000 (IWM). Her put positions would appreciate should the market decline and she could likely exit her position with a gain.
Cheryl could also sell upside calls a few percentage points above the current market price to help finance the purchase of the put strategy – sort of like what Dan did. The risk of selling upside calls is that technically, the seller’s risk is unlimited. But since the trade is short-term in nature, it seems unlikely the S&P 500 will rally by an enormous amount in that period.
For instance, if it’s late-October and Cheryl is worried about a potential market pullback around the time of the 2016 election and in the heart of earnings season, she could consider a strategy such as this:
Sell the November $218 call for an $0.85 credit.
Buy the November $212/$208 put spread for a $0.94 debit.
In this strategy, Cheryl could simply buy the $212/$208 bear put spread on the SPY for a $0.94 debit. This would protect her in the event of a pullback, but it also costs more premium.
In order to help lower that premium, Cheryl could consider selling the 218 call for $0.85. This would bring her net cost down to just $0.09 before commissions. Should the SPY close between $211.91 and $218, Cheryl’s trade won’t produce a profit – but her loss will be quite small, just the $0.09 debit.
However, should the SPY fall by just 2.8% from current prices – to $208 – Cheryl will see a gain of $3.91. This also happens to be Cheryl’s maximum gain in this scenario, which is the $4.00 spread minus the $0.09 debit.
Conversely, should the SPY rally just 2.8%, to $220, Cheryl will have a loss of $2 per share, plus the 9 cent debit she paid on the trade, for a total loss of $2.09. However, Cheryl must also consider that since she is long stock in her portfolio, she will have gains to offset this loss.
In our example, Cheryl could also consider scanning for bearish trades using the Option Party screener. Specifically, she could look for attractive bearish trades in companies with weak fundamentals, as they will likely be the first to fall if the overall market takes a turn for the worst.
Additionally, Cheryl could look for the trades that are more conservative by nature and run less risk of her experiencing a loss.
It takes practice to navigate the market, no matter what kind of participant you are. By managing risk, investors can help turn the odds in their favor that they will outperform the market and one way to manage risk is to consider hedging. In any regard, at least knowing how to hedge is an important craft in any investor’s toolbox.