Options can be used to generate extra income like in Mondays article on oil stocks. But they can also be used to protect a stock holding from a large drop in price.
With the stock market looking bearish 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 374, a December 16th expiration put with a strike price of 350 could be purchased for $9.05 per contract.
That would be $905 in total for a block of 100 shares.
The break-even price for the put option would be 340.95 and can be calculated by taking the strike price (350) and subtracting the premium paid ($9.05).
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 December 350 put option has a notional delta of -27,000. That simply means that it will roughly hedge the price risk of a $27,000 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.
Put options can help protect against large price declines and are an important risk management tool for investors.
Try A Bear Put Spread Instead
The cost of the long put could be reduced by turning it into a bear put spread. This can be done by selling a further out-of-the-money put.
For example, the December 310 strike put option could be sold yesterday for around $2.83. Selling this put would reduce the overall hedge cost by $283.
However, this would also limit the benefits of the protection below 310. The notional delta would also be reduced from -27,000 to around -18,000.
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.
*Disclaimer: On the date of publication, Gavin McMaster did not have (either directly or indirectly) positions in some of the securities mentioned in this article. All information and data in this article is solely for informational purposes. Data as of after-hours, September 22, 2022.
More Stock Market News from Barchart
/Alphabet%20Inc_%20and%20Google%20logos%20by%20IgorGolovinov%20via%20Shutterstock.jpg)
