Options can be effectively used to hedge investment portfolios against potential losses. Here are some key strategies for using options to hedge:
Put Options as Downside Protection
The most common hedging strategy involves buying put options:
Purchase put options on stocks or indices you own.
If the underlying asset's price falls, the put option increases in value, offsetting losses.
Choose a strike price and expiration date that aligns with your risk tolerance and hedging goals.
For example, an investor with a $1,000,000 portfolio correlated to the S&P 500 (SPX) could buy SPX put options to protect against a market downturn. If they allocate 2% ($20,000) for hedging, they could purchase two 3-month SPX 5,425-strike put options.
Long-Term Equity Anticipation Securities (LEAPS)
LEAPS are long-term put options with expiration dates beyond one year:
Provide extended protection against market downturns.
Often more cost-effective per month of coverage compared to shorter-term options.
Offer strategic flexibility for long-term investors.
Covered Call Writing
This strategy involves:
Owning the underlying security or index.
Selling call options against the owned position.
Collecting premium to offset potential losses, but limiting upside potential.
Dynamic Delta Hedging
For more advanced traders:
Adjust the hedge based on the option's delta as market conditions change.
Implement using futures contracts for cost-effective and liquid adjustments.
Diversification in Hedging
To optimize your hedging strategy:
Diversify across multiple underlying stocks (at least a dozen).
Use various expiration dates to reduce the risk of the entire hedge expiring worthless.
Consider different strike prices for each underlying asset.
Remember that while hedging can protect against losses, it also comes with costs and may limit potential gains. Always calculate how much you're willing to pay for protection and consider transaction costs.
How to use options before earnings release?
Trading options before an earnings release can be a strategic way to capitalize on potential price movements and volatility changes. Several strategies can be employed to use options before an earnings release:
Buying Options
Long Straddles: Purchase both a call and a put option at the same strike price and expiration date. This strategy profits from significant price movements in either direction after the earnings announcement.