Many rookie traders in search of a quick buck just love the options market for the inherent leverage. And who can blame them? Call options and put options are mega-cheap compared to the cost for such highflying stocks as Amazon.com, Inc. (NASDAQ:AMZN), Alphabet Inc (NASDAQ:GOOGL) and Tesla Inc (NASDAQ:TSLA). While the leverage afforded by stock options is sexy to be sure, these magical derivatives have oh so much more to be excited about. Maybe you haven’t heard, but stock options are an insanely effective hedging tool.
The concept of hedging is simple. It’s a protective strategy used by investors to offset or reduce risk.
Real estate provides an example you can easily relate to. If you own a home, I bet you also hold an insurance policy on the home. You pay monthly premiums to your insurance company, and they promise to compensate you for damage suffered by your home due to fire, flood and so forth.
Your insurance policy is essentially a hedge. It goes up in value in the event your house falls in value, say, by burning down or being washed away.
The stock options market is to Wall Street as the insurance marketplace is to Main Street. Except, instead of purchasing insurance for houses, cars, and boats, investors can buy insurance on their stocks and bonds which, ironically, are often worth far more than the houses and vehicles combined.
While the broad public has yet to embrace the idea of insuring stocks many professionals have. Indeed, the use of stock options for hedging purposes is commonplace among those well versed in derivatives.
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Perhaps the most popular method for hedging a stock portfolio, or individual stock position for that matter, is purchasing put options.
Remember: A put option locks in the right to sell 100 shares at a set price on or before expiration. The strategy, appropriately named the protective put, allows you to limit your downside exposure should another pesky bear market arise.
What’s particularly nice is the level of customization for using puts to hedge. You can choose the duration of the insurance, the deductible amount, and the degree of protection. You can purchase a full-fledged “Cadillac plan” put option that offers comprehensive protection, but costs a tidy sum. Or you could go with a cheap, high-deductible put option that offers catastrophic protection.
The Cadillac Hedge
For the Apple Inc. (NASDAQ:AAPL) fanboys among us we’ll use an Apple example from a few months back to illustrate hedging with put options.
Let’s say you purchased 100 shares of AAPL for a cool hundred bucks per share and have enjoyed the ascent to its current perch of $122. With $22 of unrealized profit (that’s $2,200 on 100 shares) let’s say your fears of a crash are spurring you to action. Now’s the time to grab some protection. Now’s the time for hedging.
You could lock in the right to sell AAPL near the current price for the next six months through the purchase of an April $120 put for $7.50.
Like a normal insurance policy, this hedge has a deductible, a premium and a certain level of protection.
The deductible is the amount of money you’ll lose on the stock before the protection kicks in. Since the put option grants you the right to sell AAPL at $120 you will eat the first $2 loss on the stock ($122-$120) before the hedge becomes effective; that’s the deductible.
The premium is $7.50 or roughly 6% of the total value of your position.
The protection? Well, the risk on the long stock position was limited only by the stock falling to zero. Now, you have the right to sell your shares of AAPL at $120. That reduces the potential loss on the stock from $122 to a mere $2. But wait — we also need to take into account the cost of the hedge which was $7.50. All in, we reduced the overall position risk from $122 to $9.50.
The Catastrophic Hedge
A lower-cost alternative for hedging would be buying further out-of-the-money put options. The cost is a fair bit cheaper, but the deductible is also much higher.
Going back to our Apple example, with AAPL at $122 at the time, suppose we purchased a six-month $110 put instead of the aforementioned $120 put.
The cost of the put drops to $3.85, but only locks in the right to sell AAPL shares at $110. That means you eat the first $12 loss on the stock; that’s the deductible. The premium of $3.85 is only 3% of the total value of your position. By adding the $12 deductible to the $3.85 insurance cost, you’ll discover the overall position risk is reduced from $122 to $15.85; that’s the protection.
Both hedging approaches have merit. The carrying cost of the Cadillac policy is obviously higher but affords more protection. The carrying cost of the catastrophic protection is cheaper but offers less protection.
If you’ve yet to explore the world of hedging with options, consider this your invitation to do so!