Hedging with Options
This is an introduction to various strategies for hedging with options, from basic trades to complex, multi-leg trades for protecting your portfolio or concentrated stock positions from a down turn in the market. The profits and losses in these examples do not consider commissions, interest, or taxes.
Protective Puts - (Risk: Limited / Reward: High) Protective puts are the simplest way to hedge an existing stock position. To make a pure hedge, you should buy one put contract for every 100 shares of stock you are trying to protect. To save money on the cost of this insurance, most traders will buy puts that are out-of-the-money by one or two strike prices. It's a good idea to roll your puts up if the stock price moves up, by selling your existing put and buying another with a higher strike price. Protective puts can also be placed on indexes to hedge an entire portfolio.
Married Puts - (Risk: Limited / Reward: High) Married puts are simply protective puts in which the protective put is initiated at the same time the underlying stock is bought. Like a protective put, you should buy one put contract for every 100 shares of stock you own to make a pure hedge.
Collars - (Risk: Limited - Reward: Limited) Collars are primarily used to hedge an existing position. A collar is a combination of writing (selling) a covered call and buying a protective put for your existing position. Collars are a conservative strategy that can manage risk, offer a moderate rate of return and can provide tax advantages. Many investors will roll their collars on a month to month basis. If done appropriately, this can create a moderate rate of return and allow the collar to adjust with the movement in the underlying stock. A collar is sometimes referred to as a fence.
To learn about option trading strategies for other market conditions and situations, visit our options strategy overview page.
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