A Guide to Hedging your Portfolio using Options

Although my personal trading philosophy is such that I only buy stocks when assigned on a put, I realize there are those who buy them on purpose. If you are such a trader/investor, you may want to consider using stock options as a tool for risk management.

Like an insurance policy or a discount club membership, a put or a call can be purchased in order to avoid a potentially large debit in the future. If you want to hold on to a stock, perhaps because it earns high dividends, but are afraid it will decrease in value, you can purchase a put. Purchasing a put gives you the right to sell one hundred shares of the stock at a specific price (the strike price).

The higher the strike price, the more expensive the put. Just as an insurance policy with a low deductible and lots of coverage will cost you a lot in premiums, a put whose strike price is near the current stock price will have a high market price. If you own a stock trading at, say $40/share, you may not want to pay up for a $37.50 put; it would be a significant debit, and if the stock stays above $37.50, the put will expire worthless. Like an unused insurance policy, a put that is not exercised by expiry is simply a small financial loss. (Here I mean small relative to the loss you could incur with unhedged stock trading.) If you want to get a cheaper “insurance policy”, you could purchase, say, a $30 put. If your stock falls below $30, you will have protection. However, if it only falls to, say, $37.5, you’ll be in the “deductible” range.

Buying a call is a way to speculate on the price of a stock. A call gives you the right to buy one hundred shares of stock at the strike price. If you think a $5.00/share stock will increase above $10/share between now and August, you could buy a call with an August expiration, perhaps at a strike price of $7.5 or $10. A $7.5 call is more likely to be in the money, and will have a greater potential return. It will also cost you more to buy. If you think the stock will take until January of 2009 to increase in value, you an buy a January 2009 call, but it will cost you more because the stock price has a better chance of changing by then. The writer of the call is taking more risk by selling you the call with the later expiry, and those who sell options are basically getting paid by the amount of risk they take.

Covered call writing is a good strategy to squeeze a few more dollars out of your stocks. If you own 100 shares of a stock, you can sell a call with a strike price above the stock price. You will collect a credit for selling the call, and the closer you sell to the stock price the larger the credit will be. Keep in mind, however, that if the stock price rises dramatically, you will wish you had not sold that call! Suppose you have a stock trading at $30, sell a $32.5 call and collect a $300 credit (that would be a reasonable value for a fairly volatile underlying). Now suppose that the stock price rises to $40/share. Had you not sold the call, you would have made $1000 selling the stock. However, because the call will be exercised against you, you will be forced to sell that stock at $32.5, netting a total of $550 from your stock sale and call premium. If the stock price does not increase above the strike price of the call, your sale of the call will have been a winning trade.

Covered call writing is considered a risk management strategy because it hedges you against a decrease in the price of the stock. If the stock decreases in value, the call you wrote will expire worthless, allowing you to keep the entire premium as profit, which will offset (in the example above) $300 worth of lost stock value. Once the call expires, you can sell another. You can do this indefinitely if the stock price never increases above the strike of the call you sell.

Deciding which option to buy or sell is a matter of optimizing your risk/reward ratio, and no matter what anyone else tells you, the truth is that risk management is 10% calculations and 90% intuition. I could go on for hours about the Black-Scholes model, the indicators, the charts, and lots of nifty little calculations from the balance sheet, but in the end, that’s all just data. What’s important is what you make of it.

Yes, I’m sure a lot of people read the above paragraph and smirk, but to them I pose the following conundrum: If trading is so algorithmic, why don’t you write some code and make billions? Computers are more exact at following algorithms than humans ever will be.

Of course the answer to that is simple; you need to be able to make exceptions to any trading “rules” when the situation calls for it. In other words, you need to use your own judgment, intuition, logic, whatever you want to call it. If you understand the philosophy and concepts of risk management, then you can be successful regardless of what little letters you don’t have after your name or how much you like spreadsheets. (I used to make spreadsheets. I am still recovering financially from those spreadsheet making days.) If you do need to work out a lot of calculations with a spreadsheet or on paper and cannot quickly estimate, it is probably a sign you still need to get familiar with the concepts. Algorithms will never be a substitute for good judgment.