How to Use Options for Hedging Your Stock Portfolio

When it comes to investing, it is important to safeguard your portfolio from an unexpected downturn in the market. Traditional strategies like diversification, asset allocation, and investing across asset classes are useful for reducing risk. However, using options adds extra protection when hedging your equity portfolio.

The options market, especially options trading, can be considered complex, even for those knowledgeable about its mechanics. Options hedging strategies may reduce risk, protect gains, and even enhance investment returns when used correctly. This article will provide a how-to hedge stock with options, outline hedging strategies with options and discuss options in your portfolio.

What is Hedging with Options?

Before discussing specific options hedging strategies, one must define what it means by hedging with options. Hedging means insuring your investments from adverse price fluctuations, similar to buying insurance on your overall portfolio. Options allow investors to hedge against downside risk in their stocks, where you can buy or sell the right to buy or sell an underlying asset (e.g., stock) at a predetermined price on or before a date in the future. The ability to manage upside and other risks makes options an excellent product to manage overall portfolio risk.

How to Use Options for Hedging Your Stock Portfolio

Let’s start by looking at ways to use options to hedge your stock portfolio. The basic idea is easy: you are using options contracts to try and offset possible losses in your stock. The two most common types of options utilised for hedging are puts and calls.

• Put options: Put options let you sell a stock at a fixed price (the strike price) within a certain time. They are commonly used for hedging because they protect against losses. If the stock price falls, the value of the put option rises, helping to reduce or offset your losses on the stock.
• Call options: Call options give the holder the right to buy a stock at a specific price within a set time. They are often used to hedge against upside risk or lock in profits from stock price gains before selling the stock.

Example: How to Hedge Stocks with Options

Let’s say you hold 100 shares of Reliance Industries, which is currently trading at ₹2,000 per share. You’re concerned about a potential market correction and want to protect yourself against a significant drop in price over the next month.

In this case, you could buy put options with a strike price of ₹1,900, expiring in a month, for a premium of ₹50 per share.

• If the stock price drops below ₹1,900, the value of your put option increases, allowing you to sell your shares at ₹1,900, limiting your losses. If the stock price falls to ₹1,800, your loss is capped, and the put option helps protect you.
• If the stock price stays above ₹1,900, you let the option expire and lose the ₹50 per share you paid for the premium. However, you still retain your shares and benefit from any upward movement in the stock.

Why Hedge with Options?

There are several reasons why you might want to use options for hedging your stock:

• Protection from Downside Risk: One of the most obvious advantages of hedging with options is the protection from downside risk. If the stock market drops or one of your stocks declines in price, a well-selected option—typically a put—serves as an effective insurance policy.
• Preservation of Capital: Hedging with options allows you to preserve your capital while continuing to hold your stock position. This may be particularly helpful if you have a long-term position and do not want to sell your stock due to short-term volatility.
• Lower Cost: Options are relatively inexpensive compared to other hedging alternatives. With an adequate strategy, it is possible to hedge your stock portfolio without committing excessive capital.
• Flexibility: Options provide a level of flexibility that, for other hedging instruments like futures or bonds, is not available. You can modify your options positions based on updated opinions regarding the market.
• Increased Returns: The principal objective of hedging is to lessen risk, but utilising options can also produce increased returns. Selling options (like covered calls) produce premium income that may offset losses or serve as additional income.

Popular Option Hedging Strategies

Here are some commonly used options hedging strategies to protect your stock portfolio:

1. Protective Puts (Married Puts)

Employing a protective put strategy entails buying a put option for a stock in your portfolio. If the stock price declines significantly, the put option will increase in value, leading to a smaller loss in the overall value of the initial stock. You could use the protective put option strategy if you anticipate a risk of declining stock price in the short term and want to maintain shares in the company in the long term to recover the stock value.

2. Covered Calls

A covered call strategy includes owning a stock in your portfolio and writing (selling) a call option on that stock. When you write a call on a stock you own, you collect a premium for writing this call, providing you with some potential downside protection. Covered calls are appropriate when you believe the stock price will not appreciate significantly and you want to generate some cash flow.

3. Collar Strategy

A collar strategy employs a protective put and a covered call. You first need to purchase a put option on your stock to provide downside protection, and then you need to sell a call option over your stock to help offset the purchase of the put option. A collar strategy can be effective if you wish to purchase downside protection using a put but are willing to cap your upside price potential with the covered call.

4. Long Straddle

The long straddle strategy simply involves buying a call option and a put option on the stock at the same strike price in anticipation of a large price move. A long straddle is appropriate when expecting a stock to have a large price move but doesn’t know how the price will move.

5. Long Strangle

A long strangle is similar to a straddle but uses different strike prices for the call and put options. It’s typically used when expecting high volatility, with the stock likely to move sharply but not necessarily close to a specific price point.

Conclusion

Implementing options for hedging your stock portfolio is a simple yet effective way to manage risk and protect your investments from market drops. Whether you want to hedge against downside risk, protect your capital, or generate excess income, options hedging strategies help you achieve your financial objectives more confidently. Hedging stocks with options takes a little effort, but anyone can learn this strategy with the right tools and resources. Start hedging your portfolio with Religare Broking and protect your investments against market volatility!