Options can be used to generate extra income and leverage gains on a winner — and the potential for gains is a huge incentive. But options were created largely as a method of protection. Whether that's protecting profits in an individual stock or safeguarding an entire portfolio, options are useful as a hedge against large drops in price. Today's option trade will explore using put options on SPY stock as a means of protection.
Options As Insurance
With the distribution days starting to add up on the indexes and their level of extension, it might be time to look at buying some protection on stocks that we don't necessarily want to sell.
One way of hedging a portfolio is to take an opposing position using an index. For this example, let's use the SPDR S&P 500 ETF.
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. Here, we'll be using SPY stock as our underlying asset. 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 on SPY stock gives the owner the right to sell it at a certain price, no matter how low it goes. That means if SPY stock goes down, our put will be worth more money and offset losses we may take in our portfolio. You use a hedge to give up a little upside for protection on the downside.
How To Use SPY Stock Put Options For Protection
With SPY stock trading around 492, a May 17 put with a strike price of 490 traded around $9.75, or $975 in total. The break-even price for the put option would be at a price of 480.25 for SPY stock. That calculation takes the strike price (490) and subtracts the premium paid (9.75).
Buying some protection like this using SPY stock options 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 May 490 put option has a notional delta of -42,000. This simply means that one contract on SPY stock will roughly hedge the price risk of a $42,000 portfolio of stocks.
However, it's never perfect because it all depends on the correlation of your hedge vs. your assets. You could find yourself in a position where the stocks you own drop, but SPY stock rallies. In that case, you not only fail to protect yourself, you actually lose on both sides of the trade.
Put options, whether on individual stocks or indexes like SPY stock, can help protect against large price declines. They 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 X/Twitter at @OptiontradinIQ
