Beyond just increasing returns, options can protect your stock portfolio from large drawdowns as well as enhance returns.
Backtesting:
Before examining option hedging strategies, it is important to note that any chosen strategy needs to be backtested using historical stock data for the tickers in your portfolio tickers as well as historical options data.
Protective Put (Married Put):
This is the easiest to implement hedging strategy as it involves buying put options for your stocks. If the stock price dips, the put options rise in value, offsetting portfolio losses.
For example, if the portfolio included Apple stock (AAPL) with a current market price of 130, you could purchase a 3-month put option at 110. This option would pay off in the event the stock declined below 110, effectively capping the losses at 20 per unit of stock.
Covered Call:
This strategy differs from a protective put in that it provides additional income as opposed to hedging downside risk.
You sell call options on existing stocks at strike prices above the current market price. If the stock stays flat or falls, you keep the premium. However, if the stock rises significantly, your gains are capped. Essentially, you trade some potential upside for immediate income.
For example, if the portfolio included Google stock (GOOG) with a current market price of 180, you could sell a 3-month call option at 200 for an approximate price of 3.5. This would mean collecting an additional yield of 2% (8% annualized) in return for giving up any gains above 200.
Collar Strategy:
Combining the best of both worlds, the collar strategy involves selling a call option and using the premium to buy a put option at a lower strike price. This limits your potential gains as well as potential losses by creating a defined range for your portfolio’s movement. The key benefit of this strategy is it can be a low-cost (or even zero-cost) hedging technique.
For example, if the portfolio included Airbnb stock (ABNB) with a current market price of 150, you could sell a 3-month call option at 180 for an approximate price of 1.2. Using these proceeds you could purchase a 3-month put option at 153. This would mean for a three-month period your ABNB position could only move between 153 and 180.
Long Straddle or Strangle:
For situations where significant volatility is expected (such as just after an earnings release) these strategies insulate the portfolio against large price movements. A straddle uses the same strike price, while a strangle uses different strikes. They profit from large price swings in either direction, protecting against broad market volatility rather than specific price movements. However, the cost of purchasing two options can be high.
Put Ratio Backspread:
This strategy is for those anticipating a major price drop. You sell one or more put options at a lower strike price while buying a larger number at a higher strike price. This offers protection against a significant decline while allowing you to potentially profit from a sharp drop.
For example, if the portfolio included Amazon (AMZN) stock at a current price of 120 you could sell a put option at 80 and purchase several puts at 100 using the proceeds of the sale. This would mean that the portfolio would benefit from a decline in price between 80 and 100, although the portfolio will have losses if the price declines below 80.
Diagonal Spread:
Balancing short-term downside protection with long-term upside potential, this strategy involves buying and selling options with different strike prices and expiration dates.
