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Four Ways to Hedge Your Stock Bets With Options

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Protecting your bets with option contracts.

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As you may already be aware, hedging is a popular options strategy -- and why not? Options offer a reasonably priced, low-risk method of protecting against major losses on your equity investments. This article highlights four common ways you can use option contracts to hedge your market positions.

Protect Individual Stock Investments

First off, we have the protective put, which is also referred to as a "married put." As you may already be aware, buying (to open) a put option gives you the right, but not the obligation, to sell 100 shares of the underlying stock at the strike price of the contract. This bearish strategy is described as a "long put."

So, let's say that you own 1,000 shares of Stock XYZ. It's a relatively solid stock that you've held in your portfolio for a while, yielding a considerable gain of 155%. Ideally, you'd like to keep your shares, since you're collecting a respectable dividend and you are encouraged by the company's long-term prospects.

However, there's a recent fundamental development that has made you a bit nervous. XYZ's CEO of 25 years has departed the company, and you're anxious the shift to a new chief executive could have a negative impact on the stock price.

In this scenario, there's no need to panic-sell the shares -- nor do you need to sit by helplessly and watch your profits erode. Instead, you can ease your anxieties by buying a protective put. To implement the strategy, simply buy (to open) one put option for every 100 shares you'd like to insure (in this case, you would need 10 puts to protect all 1,000 shares).

There are no strict rules, but try to match the strike price of your puts with your preferred exit price on the stock. If XYZ is hovering at $58 per share, and you don't want to own the shares below $50, considering buying the 50-strike puts. Meanwhile, choose a time frame that aligns with your expected period of weak (or uncertain) price action. In this example, you'll probably have a good idea after three months or so whether you should head for the exits, or hold onto the stock.

If your fears come to fruition and the stock declines, your put options will go in the money. You can then exercise your option to sell the shares at the strike price, thereby securing a comfortable exit price. In other words, the purchase of the put options has capped your downside risk.

However, even if the puts expire worthless, there's an upside: you still own a stock on which you're bullish long-term. Plus, the protective puts have given you peace of mind, which could help you rest a little easier at night.

Guard Against Sector-Specific Weakness

As the popularity of exchange-traded funds (ETF) continues to grow, there is an array of hedging opportunities. There are now ETFs available on nearly every sector of the market, which is great news for speculators.

Let's take a look at this example. If you own a variety of large-cap tech stocks, it would be pretty tedious to buy a protective put on each individual security (not to mention it would cost you a bundle in brokerage fees). However, that doesn't change the fact that you're concerned about the potentially negative effects of a slowdown in corporate IT spending.

If you expect this fundamental development to have an ill effect on some of your tech holdings, but you'd prefer to keep the shares over the long term, simply find an ETF that's based on the sector in question. In this example, it would be the PowerShares QQQ Trust, Series 1 ETF (NASDAQ:QQQ), which tracks powerhouse stocks such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), and Intel (NASDAQ:INTC). To hedge your large-cap tech investments, purchase one put option per 1,000 shares you'd like to insure.

The possible outcomes here are roughly the same as with a straightforward protective put. However, bear in mind that ETFs won't necessarily track the movements of your stocks directly, due to their unique compositions. For example, AAPL controls a much larger percentage of the QQQ compared with INTC. So, you could theoretically lose money on your Intel shares, while the QQQ remains perched above the strike price of your puts, due to a simultaneous surge in AAPL shares.

Happily, though, a large number of sectors have more than one dedicated ETF, so you should be able to pick and choose. Be sure to do some research before you purchase put protection, as it definitely pays to keep an eye on the weighting assigned to each asset within the ETF.

Last but not least, it bears mentioning that you will most likely not be exercising your option, as you would with a protective put -- unless you happen to have a couple hundred shares of the appropriate ETF ready to sell. Rather, if your option goes in the money, you can simply sell to close prior to expiration in order to lock in a gain.
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