Options can be used to generate extra income like a trade on Amazon.com, but can also be used to protect a stock holding from a large drop in price.
With the market uptrend under pressure, it might be time to look at buying some protection on stocks that we don't necessarily want to sell.
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 expiry.
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.
Consider SPY Stock Puts To Hedge
Let's assume we own a portfolio of stocks that we don't want to sell, but are concerned about the short-term prospects.
Instead of liquidating our portfolio, we could buy put options on the SPDR S&P 500 ETF to help cushion the effects of any downturn.
With SPY trading around 404, an Aug. 18 put with a strike price of 400 could be purchased for $13.05 late Wednesday, or $1,305 in total.
The break-even price for the put option would be 386.95. It can be calculated by taking the strike price (400) and subtracting the premium paid (13.05).
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.
This August 400 put option has a notional delta of -40,000, which simply means that it will roughly hedge the price risk of a $40,000 portfolio of stocks.
SPY Stock Put Doesn't Protect Against Individual Stocks
However, it's never perfect because you could find yourself in a position where the stocks you own drop, but SPY rallies. In that case, the hedge would not work at all.
Put options can help protect against large price declines and are an important risk management tool for investors.
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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
