Michael Martin is Vice President of Market Strategy at TradingBlock, a provider of custom trading technology solutions.
Consistent market volatility has become the new normal for traders. Everything from geopolitical conflicts to erratic policy decisions to unprecedented news cycles has markets swinging in ways that could derail any portfolio. There’s no longer a question of whether markets will be turbulent. What’s important now is how traders respond to the seemingly constant instability.
Some may choose to ride it out through passive investing, which has them banking on long-term gains to mitigate short-term losses. Others may protect themselves by scaling down certain positions. More savvy traders, however, often leverage options to hedge against the uncertainty.
Hedging with options is a lot like car insurance. Stocks crash, cars crash and then the insurance bails them out, minus the premiums they pay.
Three popular options strategies can be leveraged for hedging: protective puts, collars and covered calls. Let’s go through them one by one.
1. Protective Puts
Protective puts are the most basic form of portfolio insurance. A protective put option is when a trader buys a put option (or the right to sell an underlying asset at a specified price by a certain date) and pays a premium to protect (or insure) themselves against a steep drop in a particular stock or index.
A market crash will drive up the value of the put and offset losses. Once the stock falls below the strike price of the option purchased, the position is hedged on a 1×1 basis, meaning each dollar lost on the stock is matched by a dollar gained on the put.
In the event the market doesn’t experience a downturn, you lose the premium you paid for the option. This is like paying your insurance premiums but never getting into an accident.
The drawback is that premiums can be pricey in times of volatility.
Here is the risk/reward profile for protective puts:
Max Profit: Unlimited (stock can keep rising)
Max Loss: Stock cost – put strike + premium
Breakeven: Stock cost + premium
2. Covered Calls
The covered call, an options strategy where traders sell an out-of-the-money call option for every 100 shares of stock or an exchange-traded fund (ETF) they own, is another method of hedging. Selling a call option effectively reduces your cost basis of the stock/ETF by the amount of premium you collect. For example, if you sell a 105 strike price call for $0.50 on a stock you purchased for $100, your cost basis and breakeven point fall to $99.50.
While doing little for downside protection, a covered call can help generate income when markets are sideways.
Here is the risk/reward profile for covered calls:
Max Profit: Call strike – stock cost + premium
Max Loss: Stock cost – premium (to zero)
Breakeven: Stock cost – premium
3. Collars
Collars can be a cost-effective alternative to protective puts. This strategy combines both a protective put and a covered call by buying an out-of-the-money put and selling an out-of-the-money call on 100 long shares of a stock or ETF. Many traders prefer the “zero-cost” collar, which means the debit you pay for the put is equal to the credit you receive from the call.
The trade-off is that while your downside is protected, your upside is capped once the stock moves above the short call strike, so you can’t participate in further gains.
Here is the risk/reward profile for collars:
Max Profit: Call strike – stock cost ± net premium
Max Loss: Stock cost – put strike + net premium
Breakeven: Stock cost + net premium
When Hedging Works (And Doesn’t Work)
The most difficult part of using options as a mechanism for hedging is getting the timing right. As I recently explained to a trader, “Time decay accelerates quickly around 30 days to expiration, so holding long options too close to expiration can leave them worthless if they finish out of the money.”
The car insurance analogy highlights the risk and reward of hedging with options. It can offer protection when you need it, but it may cost you if you overpay for the protection or hedge at the wrong time. For example, one study found that during a 14.6% market decline, protective puts softened the blow but still left an investor with nearly a 13% loss.
If a trader waits for volatility to spike before they use options for protection, they’ll encounter inflated premiums and quickly discover that the cost of the hedge erodes the return, especially if an expected downturn never comes to fruition. I’ve seen traders rush to short-dated puts ahead of an event like a quarterly earnings report or Federal Reserve announcement, only to see markets regain stability and have those options expire without any value.
Hedges work best during sharp, unexpected downturns and are less effective when markets slowly slide. It’s also important to understand the trade-offs between the cost of coverage and the protection it provides, as well as what you gain in peace of mind versus the drag you’ll experience on returns.
Smartly timed hedges can mean the difference between thriving amid volatility and simply surviving it.
Today’s traders are seemingly at the mercy of a constant deluge of market-shifting headlines. And while hedging with options isn’t a panacea, it can help traders remain invested while protecting them against movement that can sting a portfolio.
Just like insurance, there’s a price to pay for the protection. The key is understanding your time horizon, risk tolerance and the trade-offs that come with hedging with options. They can preserve your ability to reap the rewards of long-term growth while protecting you from crashes. And just like car insurance, you’ll be thankful you have it when you need it most.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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