If you’ve spent some time investing you know that the market has periods of volatility, not only where selling pressure threatens to create a correction or bear market, but also when stocks are trading at all-time highs. When stocks appear overvalued, trading at high earnings per share multiples for instance, or following a rapid run up, it can be tempting to let fear of lost profits drive your decision making. And while there’s certainly nothing wrong with taking some profits off the table, moving entirely to cash is usually a mistake. If you find yourself considering an all-cash portfolio, you may want to think about implementing a strategy to hedge your portfolio instead.
There are several options strategies that you can implement to hedge your portfolio. Because I can’t possibly know what you have in your portfolio, I’ll base the strategies on the SPDR S&P 500 ETF (SPY), which corresponds to the price and yield performance of the S&P 500 Index.
(Note: You may not be allowed to hedge your mutual fund holdings by trading the SPY. For instance, if you own mutual fund XYZ, your broker may not allow you to sell calls in the SPY because they don’t move in exact correlation. But that is a conversation you should have with your brokerage provider.)
Covered Call, Put Purchase, and Risk Reversal to Hedge Your Portfolio
Here are three strategies you can use to hedge your portfolio.
A covered call is a risk-reducing strategy for which a call option is written (sold) against an existing stock position on a share-for-share basis. The call is said to be “covered” by the underlying stock, which could be delivered if the call option is exercised.
This is a great way to create yield in your portfolio, though I will say it does not hedge your portfolio entirely. If the SPY were to drop dramatically, you would collect the premium taken in, but you would still be long the stock.
So, for example, you own 100 shares of the SPY, and therefore you are able to sell one call against your stock so that you are covered.
The premium you receive for that call depends on a number of factors, but there are two which you can control: time to expiration and strike price. If you’re concerned about short-term volatility due to specific upcoming events in the market or the news, you can consider selling short-term calls with strike prices “near-the-money,” meaning a few percentage points above the current price. Alternatively, if you’re simply concerned that a position has become overvalued but are still bullish in the long term, you could sell calls with a strike price that is further “out-of-the-money” with more time to expiration. Typically, more time to expiration and closer to the current price equals higher premiums received due to the greater risk of getting the shares called away.
It’s important to remember that the rationale behind a covered call is that you are bullish on your investment and want to keep it, but are looking for ways to reduce your risk or generate income. As a call seller your shares can be called away at any time at the price you specified, so sell calls with a strike price that you’d be willing to sell your underlying shares at.
Once again assuming you own 100 shares of the SPY, the truest way to hedge your portfolio would be to buy one put against it. If the SPY were to drop below your put’s strike price, you could simply exercise your put, and you would be out of your entire stock position. The upside to this strategy is that you do not cap the potential profit if the SPY price continues to rise.
Again, you can choose any number of strikes and timeframes for this strategy.
In this scenario, your maximum loss is the difference between the current value of SPY and the strike price plus the cost of the put you purchased. While in this instance you’re paying a premium for insurance as opposed to collecting a premium, the underlying strategy remains the same: you’re bullish on the position. If you find yourself repeatedly buying puts to hedge your portfolio, you may not be as bullish on that investment as you think and it may be worth considering selling instead of paying premiums every month or two.
This is a more sophisticated strategy, but is a truer way to hedge your portfolio than a covered call.
In this example, you will be selling a call that is out-of-the-money and buying a put that is out-of-the-money. This is a strategy that will reduce the capital that you have to pay for your hedge, but it limits your upside.
This trade creates three possible outcomes, SPY falls below your put price, rises above your call price, or trades in the range between the two strike prices. Because the price of SPY changes daily, let’s use round numbers as a hypothetical example. If SPY is trading at 375, you could sell a covered call that goes out a few months at 395 for $400, and buy a put with the same expiration with a strike at 365 for $800. The net cost to you is $400 (cost of the put less price received for the call).
In this scenario if the SPY closes below 365 at expiration you’ll put the shares to the seller and are out of the position at 361 (365 strike price less $4/share cost of the trade). If SPY closes above 395, your shares will be called away and you’re out of the position at 391 (395 strike price less $4/share cost of the trade). If SPY closes anywhere in between those strike prices you will retain your shares and have simply lost the price of insurance (which you reduced by selling that call).
You can use any of these strategies against any of your optionable equity or index holdings. If you have concentrated positions in single equities or sectors, you can use these strategies to hedge your portfolio on those individual stocks or an ETF that closely aligns with your sector exposure.
If you want to hedge your mutual fund holdings, talk to your brokerage provider to see how you can implement strategies like these.
With a little education, options trading can be simple, low-risk, fun and most importantly, profitable.