Banking

How A Put Option In SPY Hedges Your Portfolio

Options can be used to generate extra income like this trade on Arbor Realty Trust (ABR). But they can also help protect a stock holding from a large drop in price. This column focuses on the art of hedging with options.




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When traders feel worried about a downturn in the market, they can look at buying some protection via put options.

A put option is a financial contract that gives the holder the right, but not the obligation, to sell a certain underlying asset at a certain price on or before expiration. For this right, the buyer of the put option pays a premium to the option seller. Think of it like buying insurance against your house burning down.

You as the homeowner pay the insurance premium. And the options seller acts like the insurance company.

Owning a put option gives the owner the right to sell their stock at a certain price, no matter how low it goes. So, the owner earns downside protection, and still gets to benefit on the upside.

Hedging With Options: The SPY Put

Let’s assume we own a portfolio of stocks that we don’t want to sell. But we still harbor concern about the short-term prospects.

Instead of liquidating our equities portfolio, we could buy put options on the SPDR S&P 500 (SPY) exchange traded fund to help cushion the effects of any downturn.

On Tuesday, with the SPY trading around 456, a Dec. 17 expiration put with a strike price of 440 could be purchased for $5.60 per contract.

That would total $560 in cost for a block of 100 shares.

The breakeven price for the put option would be 434.40. Calculate this by taking the strike price (440) and subtracting the premium paid per share (5.60).

Buying some protection like this can be expensive. However, the benefit of hedging with options is clear. It can also help us sleep a little better at night if we are concerned about a large drop in stocks over the next month or so.

This June 410 put option has a notional delta of -13,250. That simply means that it will roughly hedge the price risk of a $13,250 portfolio of stocks.

This Can Happen Too When Hedging An Index

However, it’s never perfect. You could find yourself in a position where the stocks you own drop but SPY stock rallies, in which case the hedge would not work at all. Traders with a large proportion of tech stocks in their portfolio may prefer to buy puts on Nasdaq QQQ Trust ETF (QQQ).

The other possibility? You could also buy put options on each specific stock in a portfolio. But that can be costly and time consuming.

Put options can help protect against large price declines and are an important risk management tool for investors.

Please remember that options are risky, and investors can lose 100% of their investment.

Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ.

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