The 6-Week Options Trading Kickstarter: Hedging, Portfolio Protection, and Avoiding Disaster
Steve Smith discusses using options to protect your positions and portfolio.
Hedging and Protection
In my options trading at OptionSmith, I try to have individual positions that have their own internal hedges by using spreads. These usually take the form of basic vertical spreads or calendar spreads. The essential function of a spread is that by both buying and selling options on the same underlying security, you will be reducing the impact of changes in implied volatility and time. The strategy you choose will determine which variable you want to de-emphasize.
I also frequently use options on the Spyder Trust (NYSEARCA:SPY) to provide the overall portfolio with broader protection. Typically, individual positions tend to be bullish, while the portfolio protection chunk usually consists of the purchase of puts or put spreads. Let's take a look at how this concept can be applied to a less active and basically bullish-oriented portfolio.
Buying put options does offer the most complete and probably efficient way to hedge a position, but it comes at a cost. That cost, as with all insurance policies, will be a function of the amount of protection and its duration.
The main items to consider when choosing put protection, whether for an individual stock or a broad equity portfolio, are as follows:
- What magnitude of a decline is expected?
- At what level of the decline do you want the position to be fully hedged or protected?
- For what length of time do you want the protection in place?
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