With stocks near all-time highs and an explosion in buying call options, it’s easy to forget that options were designed primarily as hedging products.
This article breaks down an example of hedging options and explains the benefits and costs involved.
Buying a put option is best visualized as buying insurance.
In today’s society, we can get insurance for almost anything.
From our microwave, our car, our house to our lives.
It’s the same on the stock market. We have a variety of put options to choose from.
Deciding which option to choose can be daunting.
However, once you understand the products available and how they work, any investor can build a prudent portfolio.
A Portfolio This can lead to long-term returns, but it also allows you to get a good night’s sleep.
Buy a put option gives an investor the right to sell an asset at or below a certain price.
This price results from the exercise price (shown in green).
When we buy a put option, we buy that right for a certain period of time.
This is known as the day to expiration, or DTE (shown in yellow).
The final component is the premium.
This is the price paid for the put contract.
In this arbitrary example, we’re looking at the 255 strike (shown in red).
If we buy this put option, we have the right to sell FB shares if they go below $ 255 in the next 20 days.
Having this right is not free.
This put option will cost approximately $ 5.30 to purchase.
The payout is visualized below. Remember, long stocks pose unlimited downside risk until the stock hits $ 0.
When using the put option, our loss is limited to the distance between the current price and our exercise price plus the premium paid.
Even for someone who just watched the Social Experiment on Netflix, a price of $ 0 for Facebook in the next twenty days is unrealistic.
The risk profile for a correction up to USD 220 is shown here.
Long 100 shares
$ 261.60 – $ 220 x 100 shares = loss $ 4,160
Long 100 shares, long 255 put.
$ 261.60 – $ 255 + $ 5.30 = $ 11.80 x 100 shares = Maximum loss $ 1,190
Note that the put option limits our loss to $ 1,190.
Limited downside risk and unlimited upside potential, sign me up!
But before you go out and buy, bet on every stock you have here is the catch.
There has to be one for every put buyer Seller.
The seller in the insurance example is the insurer.
Your goal is to make money.
You get a bonus but are hooked in return for serious, sometimes unlimited, losses.
Earning a few hundred dollars a month to make sure people are against a hurricane sounds great until the hurricane hits.
To provide an incentive to sell insurance (or, in this case, sell the put), an additional premium must be paid.
It is embedded in the option price.
In the case of options, this is known as the risk of variance premium.
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The risk of variance premiums are a phenomenon where put options tend to be overpriced compared to their theoretical values over time.
Likewise, insurance is usually overpriced in relation to its value.
This doesn’t mean it is always overpriced.
After all, taking out insurance just before a hurricane pays off.
There is more good news for put buyers.
Unlike home insurers, very few regulations are required to sell puts.
A few thousand dollars and some specs and you can sell puts in your account.
This competition for the insurance you buy lowers the premium in some places to a level that becomes attractive.
Deciding whether and when to buy a put can be a complex decision. I like Aaron Brown, a Chief Risk Manager at AQR.
“Take the risks we want and hedge the risks we don’t.”
To see what risks we have, we need to emphasize our positions when things go wrong. If we cannot cope emotionally or financially with the worst-case scenario, we need to look for ways to reduce that risk or hedge it.
Most people would say that it is stupid not to buy home insurance.
The reason for this is not that home insurance has a positive expected value.
In the worst case scenario, there is no risk in imagining that your home has collapsed in front of you without insurance.
Conversely, buying insurance for your microwave probably doesn’t make sense. If your microwave breaks, you can just spend $ 40 to buy a new one.
It’s a risk we can take.
In the case of insurance, we often have more information than the insurer.
If I have two children who like to make sick anything they can get their hands on in the microwave, then buying insurance may have positive expectation.
That’s for another article.
Back to our portfolio, we probably don’t have any classified material information about the companies in our holdings.
Therefore, our goal is to reduce the risks that we do not want to have.
The first thing a new options investor will notice is the multitude of different option strikes and operations.
Choosing which strike to buy is relatively easy as it is all based on your risk tolerance.
Ask yourself what is the maximum loss I can suffer in this position. Start there.
Since options are usually overpriced, we usually want to look for cheaper rear risk insurance, even if it’s in volatility Conditions this insurance is more expensive.
In order to choose our days to expire, we would like to consider our investment schedule. Are we planning to hold this investment for a month or a year?
If it is a longer term investmentBuying puts weekly doesn’t make much sense.
The simple reason, increased commission costs and slip-ups.
Conversely, taking out insurance for the whole year is also not in our best interests if we are concerned about a specific event.
For the average investor with a longer-term portfolio, I would recommend looking into longer-term options (3-6 months).
This gives you plenty of time not to over-manage your position, but to adjust quarterly as things change.
Pick a put strike that is far from the money and see if it makes sense for you to purchase this protection.
Often times, the best insurance is simple.
I find it ironic how many retail investors I know have a long portfolio of stocks and decide to hedge it VIX / VXX calls.
If you want to buy a single put option on a long stock portfolio, consider buying a put on the S&P 500.
VIX does not call hedging volatility risk the price risk.
Just because volatility and index price are highly correlated doesn’t mean they always move together.
Below I’ve plotted the S&P returns versus the VIX.
If the stock market falls 1% tomorrow, I can’t promise you that volatility will increase, it is just likely.
This is shown by the few outlier points circled in the graphic above.
When you get insurance for your neighbor’s house, you can be protected from most natural disasters in your area.
However, you are not protected from a falling tree Your House.
Unless there is a fundamental reason why you think your neighbor’s insurance is mispriced, buy puts on the coverage you actually need.
** For those of you who are buying VXX, research is being carried out against a portfolio of stocks, like the VIX The curve rolls in contango before you think your insurance is free **
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We know that the premium put options are overpriced due to the risk of variance. So why not set a stop loss instead?
This is a fair question; We can keep our premium and still have some form of risk management.
All of this for free.
Still, we are missing two things.
- A stop loss does not prevent us from jumping in prices. Let’s imagine I enter a stop-loss order for $ 255 on Facebook (according to the original example). Overnight we have news of a new Congressional investigation into breaking big tech. Facebook opens at $ 230 the next day and we’re filled at that price, not $ 255.
- in case of a Flash crashyour stop loss will be executed. Chances are, you have no intention of selling your Facebook stock at a 10% discount if nothing has changed. If the market recovers 10 minutes later, it doesn’t matter. You are unable to. Conversely, with the put option, we continue to hold the option and the shares. If we had a full boom, we would not suffer losses and probably make some money for ours Vega exposure.
This doesn’t mean that using stop losses is a bad idea.
If we are familiar with these risks and think the put options are too expensive, this is a sensible alternative.
Today we looked in depth at using puts as an example of hedging options.
Put options offer protection for the risks that we cannot otherwise reduce.
We can hedge our portfolio exactly to the desired level without the risk of stop losses and other conditional orders.
So ask yourself, do you have risks that you don’t want to take?
In this case, put options should be considered to hedge this risk.
Disclaimer: The information above applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.