Options can be used to generate extra income like in this trade idea on JP Morgan. But they can also be used to protect a stock holding from a large drop in price.
With the stock market looking fragile here, 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 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.
Instead of liquidating our portfolio, we could buy put options on the Spdr S&P 500 (SPY) to help cushion the effects of any downturn.
Yesterday, with the SPY trading around $446, a December 15th expiration put with a strike price of $445 could be purchased for $9.60 per contract.
That would be $960 in total for a block of 100 shares.
The break-even price for the put option would be $435.40 and can be calculated by taking the strike price ($445) and subtracting the premium paid ($9.60).
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 December $445 put option has a notional delta of -18,600. That simply means that it will roughly hedge the price risk of a $18,600 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.
Put options can help protect against large price declines and are an important risk management tool for investors.
Consider the Bear Put Spread
While buying a single put option provides protection, the cost can be significant. Investors can optimize their insurance strategy and reduce the expense by employing a bear put spread.
This advanced technique involves selling a further out-of-the-money put option.
For instance, you could sell a December 410 strike put option, which might have been trading at around $3.08.
By selling this put, you effectively lower the overall cost of the insurance by $308.
However, it's important to recognize that this strategy comes with a trade-off; it limits the benefits of protection below the $410 strike price.
Additionally, the notional delta, or the extent to which the hedge offsets your portfolio's risk, is reduced from -18,600 to around -12,500.
Summary
In summary, put options are a powerful tool for investors looking to protect their portfolios during uncertain market conditions.
By understanding the fundamentals of these options and exploring advanced strategies like the bear put spread, investors can tailor their risk management approaches to meet their specific needs and market outlooks.
Please 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.
On the date of publication, Gavin McMaster did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
