Options can be used to generate extra income, like in last week’s Amazon (AMZN) bull put spread example. But they can also be used to protect a stock holding, like SPY stock, from a large drop in price.
When traders are worried about a downturn in the market, they can look at buying some protection via put options with SPDR S&P 500 (SPY).
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 is 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. The downside is protected while the investor still gets to benefit in the upside.
Let’s assume we own a portfolio of stocks that we don’t want to sell but are concerned about the short-term prospects.
SPY Stock Put Option
Instead of liquidating our portfolio, we could buy put options on SPY stock to help cushion the effects of any downturn.
Yesterday, with the SPY stock trading around 417, a June 18 expiration put with a strike price of 410 could be purchased for $6.85 per contract.
That would be $685 in total for a block of 100 shares.
The break-even price for the put option would be 403.15. It’s calculated by taking the strike price (410) and subtracting the premium paid ($6.85).
Buying some protection like this can be expensive. But 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 -16,000. That simply means that it will roughly hedge the price risk of a $16,000 portfolio of stocks.
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 is buying 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.
It’s important to remember that options are risky and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
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
YOU MIGHT ALSO LIKE: