When the stock market is turbulent, it makes sense to hedge some of your valuable equity positions. One way to do it is through options.
The adage “Don’t keep all your eggs in one basket” is well-known among investors. While a diversified portfolio reduces your risk, you probably have a handful of favorite stocks that you don’t want to sell. But watching those stocks lose value can be painful.
The good news: There is a way to reduce your losses on those positions.
Hedging With Options
Before diving into the strategies, you need to determine what you want to do with the stocks you want to hold on to. When a market is trending lower, options help protect your investments in the following ways:
Protecting your stocks against losses.
Generating income from declining stock values.
Realizing profits from declining stocks if the stock moves in your favor.
Before proceeding further, look at all your portfolio holdings and determine which stocks you want to hold on to, then determine your hedging objectives.
This article will focus on the strategies you can implement to protect your stocks against losses. You can do this by buying puts, which are similar to an insurance policy. You pay for downside protection to gain unlimited upside potential.
Here’s how it works.
You buy one put contract for 100 shares of an underlying stock. For example, if you own 100 shares of Apple, Inc. (AAPL), you buy one AAPL put contract; if you own 200 shares of AAPL, you could buy 2 put contracts.
You buy a put with a strike price that could generate a profit that you’re comfortable with on your equity position, and a premium (the price of the contract) that you’re willing to pay to protect your position.
If the stock’s price falls below the strike price, you could sell your put contract for a profit. You could also choose to exercise your put contract, i.e., selling the underlying shares at the contract’s strike price.
For example, say you bought 100 shares of AAPL for $110 per share. AAPL stock is trading slightly below $205 but hit a high of $259.81. You want to protect your unrealized gains in case the price falls further. Looking at the daily chart of AAPL below, further downside looks highly probable.
The 50-day simple moving average (SMA) has crossed below the 200-day, the StockCharts Technical Rank (SCTR) score is at 32.50, which is relatively low, and the relative strength index (RSI) just below 50, indicating neutral momentum.
FIGURE 1. DAILY CHART OF AAPL STOCK. A declining trend, a technically weak chart, and lukewarm momentum indicate a higher probability of further decline.Chart source: StockCharts.com. For educational purposes.
If you were to buy a put, what strike price and expiration would you choose? That can be a time-consuming exercise, but the OptionsPlay Add-on in StockCharts does it for you quickly. Here’s how.
Below the chart, click the Options menu, found under Tools & Resources. You’ll see the Options Chain by default (Options Summary).
Click the OptionsPlay button above the Options Chain to access the OptionsPlay Explorer. You’ll see the three optimal strategies listed.
FIGURE 2. OPTIMAL OPTIONS STRATEGIES FOR AAPL STOCK. You could sell 100 shares of AAPL, buy a put, or buy a put vertical spread. You can analyze the three scenarios and determine which one will help protect your equity position.Image source: StockCharts.com. For educational purposes.
The recommended long put (displayed in the middle) is the June 20 $205 put, which will cost $1,170. You have to decide if it’s worth paying this much premium to protect your position in the stock. If the stock price rises above $205 by expiration, your contract will expire worthless. You would have lost $1,170. Are you willing to take that risk?
You can modify the strategy by changing the expiration and strike price of the contract. This will help determine if there are more favorable risk-to-reward scenarios. The following scenarios could play out:
Scenario 1: The stock price falls below $205.
You could sell the put option for a profit, which will offset some of the unrealized losses from the decline in the stock’s price.
You could also choose to exercise the option and sell the shares for $205. You would walk away with a profit of $8,330 ($9,500 – 1,170).
Scenario 2: The stock price is above $205 by expiration.
Your put contract will expire worthless.
If you think the stock price will drop as contract expiration gets close, you could roll it to a further-out expiration. You’d sell your $205 June put and purchase another put option with a later expiration.
When buying puts, your maximum risk is limited to what you pay for the premium.
There’s More You Can Do
The strategy on the right shows a put vertical strategy, which has a much lower cost, a higher OptionsPlay score, and a potential reward of $2,145, which is much lower than buying a put.
The put vertical involves adding a lower strike price put with the same expiration. This would be a two-leg options trade—you buy the June 20 205 put and sell the June 20 $175 put.
The benefit of the put vertical is that you limit your risk to $855 (the debit). This will happen if AAPL is above $205 and both puts expire worthless.
Your potential reward is limited to $2,145 (strike price – debit), which you will realize if AAPL’s stock price falls below $175. The probability of profit of the put vertical is 41.79%, versus 37.48% for the long put.
The Bottom Line
Buying puts and put vertical spreads can protect your options positions in a declining market. You still need to evaluate the cost of protection versus your profit potential, just as you would when you’re shopping for insurance.
The benefit of using the OptionsPlay Add-on is that the legwork is done for you. All you have to do is evaluate the different strategies, which are spelled out for you in simple terms. To learn more about the features available in the OptionsPlay Add-on, visit the StockCharts TV OptionsPlay with Tony Zhang YouTube channel.
Disclaimer: This blog is for educational purposes only and should not be construed as financial advice. The ideas and strategies should never be used without first assessing your personal and financial situation or without consulting a financial professional.