Hedging strategies are used by investors to reduce their exposure to risk in the event that an asset in their portfolio is subject to a sudden price decline. When properly done, hedging strategies reduce uncertainty and limit losses without significantly reducing the potential rate of return.
Usually, investors purchase securities inversely correlated with a vulnerable asset in their portfolio. In the event of an adverse price movement in the vulnerable asset, the inversely correlated security should move in the opposite direction, acting as a hedge against any losses. Some investors also purchase financial instruments called derivatives. When used in a strategic fashion, derivatives can limit investors' losses to a fixed amount. A put option on a stock or index is a classic hedging instrument.
Key Takeaways
- A hedge is an investment that protects your portfolio from adverse price movements.
- Put options give investors the right to sell an asset at a specified price within a predetermined time frame.
- Investors can buy put options as a form of downside protection for their long positions.
- The pricing of options is determined by their downside risk, which is the likelihood that the stock or index that they are hedging will lose value if there is a change in market conditions.
- Options tend to be cheaper the further they are from expiration, and the further away they are from the money.
How Put Options Work
With a put option, you can sell a stock at a specified price within a given time frame. For example, an investor named Sarah buys a stock at $14 per share. Sarah assumes that the price will go up, but in the event that the stock value plummets, Sarah can pay a small fee ($7) to guarantee she can exercise her put option and sell the stock at $10 within a one-year time frame.
If in six months the value of the stock she purchased has increased to $16, Sarah will not exercise her put option and will have lost $7. However, if in six months the value of the stock decreases to $8, Sarah can sell the stock she bought (at $14 per share) for $10 per share. With the put option, Sarah limited her losses to $4 per share. Without the put option, Sarah would have lost $6 per share.
Option Pricing Determined by Downside Risk
The pricing of derivatives is related to the downside risk in the underlying security. Downside risk is an estimate of the likeliness that the value of a stock will drop if market conditions change. An investor would consider this measure to understand how much they stand to lose as the result of a decline and decide if they are going to use a hedging strategy like a put option.
By purchasing a put option, an investor is transferring the downside risk to the seller. In general, the more downside risk the purchaser of the hedge seeks to transfer to the seller, the more expensive the hedge will be.
Downside risk is based on time and volatility. If a security is capable of significant price movements on a daily basis, then an option on that security that expires weeks, months, or years in the future would be considered risky and thus be more expensive. Conversely, if a security is relatively stable on a daily basis, there is less downside risk, and the option will be less expensive.
Call options give investors the right to buy the underlying security; put options give investors the right to sell the underlying security.
Consider Expiration Date and Strike Price
Once an investor has chosen a stock for an options trade, there are two key considerations: the time frame until the option expires and the strike price. The strike price is the price at which the option can be exercised. It is also sometimes known as the exercise price.
Options with higher strike prices are more expensive because the seller is taking on more risk. However, options with higher strike prices provide more price protection for the purchaser.
Ideally, the purchase price of the put option would be exactly equal to the expected downside risk of the underlying security. This would be a perfectly-priced hedge. However, if this were the case, there would be little reason not to hedge every investment.
7%
The percentage of options that are exercised, according to the Financial Industry Regulatory Authority. The remainder expire worthless or are closed out before expiration.
Risks and Costs of Put Options
Of course, the market is nowhere near that efficient, precise, or generous. There are three important factors in the cost of any options strategy:
- Volatility Premium:Implied volatility is usually higher than realized volatility for most securities. The reason for this is open to debate, but the result is that investors regularly overpay for downside protection.
- Index Drift:Equity indexes and associated stock prices have a tendency to move upward over time. When the value of the underlying security gradually increases, the value of the put option gradually declines.
- Time Decay:Like all long option positions, every day that an option moves closer to its expiration date, it loses some of its value. The rate of decay increases as the time left on the option decreases.
Because higher strike prices make for more expensive put options, the challenge for investors is to only buy as much protection as they need. This generally means purchasing put options at lower strike prices and thus, assuming more of the security's downside risk.
Long-Term Put Options
Investors are often more concerned with hedging against moderate price declines than severe declines, as these types of price drops are both very unpredictable and relatively common. For these investors, a bear put spread can be a cost-effective hedging strategy.
In a bear put spread, the investor buys a put with a higher strike price and also sells one with a lower strike price with the same expiration date. This only provides limited protection because the maximum payout is the difference between the two strike prices. However, this is often enough protection to handle either a mild or moderate downturn.
Another way to get the most value out of a hedge is to purchase a long-term put option or the put option with the longest expiration date. A six-month put option is not always twice the price of a three-month put option. When purchasing an option, the marginal cost of each additional month is lower than the last.
Example of a Long-Term Put Option
The following chart shows some of the put options available on iShares Russell 2000 Index ETF (IWM). As of June 13, 2022, IWM was trading at $178.59.
| Cost of At-the-Money Put Options for IWM | |||
|---|---|---|---|
| Strike | Days to Expiry | Cost | Cost/Day |
| 179 | 31 | 6.27 | 0.202 |
| 179 | 70 | 9.38 | 0.134 |
| 180 | 189 | 15.14 | 0.080 |
| 180 | 371 | 18.92 | 0.051 |
In the above example, the most expensive option also provides an investor with the least expensive protection per day.
This also means that put options can be extended very cost-effectively. If an investor has a six-month put option on a security with a determined strike price, it can be sold and replaced with a 12-month put option with the same strike price. This strategy can be done repeatedly and is referred to as rolling a put option forward.
By rolling a put option forward, while keeping the strike price below (but close to) the market price, an investor can maintain a hedge for many years.
Calendar Spreads
Adding extra months to a put option gets cheaper the more times you extend the expiration date. This hedging strategy also creates an opportunity to use what are called calendar spreads. Calendar spreads are created by purchasing a long-term put option and selling a short-term put option at the same strike price.
However, this practice does not decrease the investor's downside risk for the moment. If the stock price declines significantly in the coming months, the investor may face some difficult decisions. They must decide if they want to exercise the long-term put option, losing its remaining time value, or if they want to buy back the shorter put option and risk tying up even more money in a losing position.
In favorable circ*mstances, a calendar spread results in a cheap, long-term hedge that can then be rolled forward indefinitely. However, without adequate research the investor may inadvertently introduce new risks into their investment portfolios with this hedging strategy.
Long-Term Put Options Are Cost-Effective
When making the decision to hedge an investment with a put option, it's important to follow a two-step approach. First, determine what level of risk is acceptable. Then, identify what transactions can cost-effectively mitigate this risk.
As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments. Long-term put options can be rolled forward to extend the expiration date, ensuring that an appropriate hedge is always in place.
Keep in mind that some investments are easier to hedge than others. Put options for broad indexes are cheaper than individual stocks because they have lower volatility.
It's important to note that put options are only intended to help eliminate risk in the event of a sudden price decline. Hedging strategies should always be combined with other portfolio management techniques like diversification, rebalancing, and a rigorous process for analyzing and selecting securities.
How Do You Hedge Stocks With Options?
Options allow investors to hedge their positions against adverse price movements. If an investor has a substantial long position on a certain stock, they may buy put options as a form of downside protection. If the stock price falls, the put option allows the investor to sell the stock at a higher price than the spot market, thereby allowing them to recoup their losses.
What Is Delta in Options Trading?
In options trading, delta is a risk metric that estimates the expected change of an options price based on the predicted change of the underlying asset. For example, a call option with a delta of +0.65 will experience a 65% change in value, if the price underlying security increases by $1. The delta of a call option is always greater than or equal to zero. For put options, the delta is less than or equal to zero.
How Much Do Options Traders Make?
An options trader in the United States earns an average salary of $134,000 per year, according to ZipRecruiter. That's before adding in any performance-related bonuses or incentives.
The Bottom Line
Options trading offers a convenient way to hedge their portfolio against sudden price declines. By investing in long-term put options, a trader can reduce their risk exposure and ensure that they can still sell their assets at a satisfactory price, even if the market moves against them.
