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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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Shield Your Portfolio From Broad-Market Mayhem

The natural progression of this idea is to purchase protective puts on the entire equities market. This is a handy strategy during bear markets, bull-market pullbacks, or other periods of generally lackluster price action for securities.

Admit it: even in the worst of all possible markets, you're probably not going to empty your entire portfolio and run for the hills. Even so, it's never pleasant to watch your losses mount. Even if you're a firm, long-term buy-and-holder, nobody wants to see their profits dwindle.

Luckily, put options enable you to profit from negative price action, whether in a single equity or the entire market. By buying puts on an index, you can gain even while your portfolio flounders.

The concept here is similar to the ETF hedge. However, it's worth noting that a number of options on broad-market indexes are European-style, which means they offer limited flexibility. Also, if you check out an option chain for the S&P 500 Index (INDEXSP:.INX), you'll see that they're not very liquid.

Alternatively, those seeking to hedge against widespread weakness often turn to the S&P Depository Receipts, a.k.a. the SPDR S&P 500 ETF Trust. Whatever name you prefer, it trades under the ticker symbol (NYSEARCA:SPY). This ETF is based directly on the movements of the SPX, but at a fraction of the cost. SPY options are both reasonably priced and liquid, and offer an ideal way to hedge against the broader equities market.

Of course, depending on the makeup of your portfolio, you might be better off employing the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), based on the Dow Jones Industrial Average (INDEXDJX:.DJI), or the iShares Russell 2000 Index ETF (NYSEARCA:IWM), which is based on the small-cap rich Russell 2000 Index (INDEXRUSSELL:RUT).

As with any ETF hedge, you're not necessarily going to get a perfect inverse correlation between your stock losses and your put-related gains. Still, the utilization of index puts can ideally help cap your downside risk, and again, give you with peace of mind during periods of market uncertainty.
No positions in stocks mentioned.
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