Although many people trade options in place of stocks, they were originally created to hedge stock positions and they can do that quite well if you know what you’re doing.
I’ll share with you 3 different strategies on how you can use options to protect your primary positions, whether it is stocks, commodities, futures or currencies.
Strategy #1: Buy a Put.
Buying a put against your position is the most simple of the 3 strategies and therefore we will look at it first.
Buying a put is like going short the stock, but it’s less expensive because of the leverage provided by options.
If you were to buy 100 shares of IBM, you could buy 1 IBM put to protect you against your IBM stock from taking a dramatic gap through your stop.
This is very much like buying an insurance policy. You’re paying a small premium (the cost of the put) which you can afford to prevent a disaster (a huge gap against your position) which you cannot afford.
Of course the price of the option cuts into your profits a little bit, so the market has to move in your direction more than it otherwise would have, in order for you to start making money.
The closer the strike price of the option you buy is to the price of the stock, the more you will pay for the option. This is because the strike price is the price at which you generally start making money on the put if the stock goes down.
Below is an option chain that contains IBM puts.
You’ll notice 2 things:
If you bought 1 contract of the April put with a strike price of 90, the risk graph below shows how much you would make or lose on the put as IBM goes up or down in price (please note that risk graphs can change over the life of an option).
As you can see, if IBM goes below 90, you would of course lose money on your stock, but you would make money on the put, thereby offsetting the loss on the stock.
The IBM April 90 put is expensive ($540) because you are buying the put so close to the current price of the stock and thus almost fully insuring your position. If IBM goes up, the price of your put will go down and you will lose money on the put you purchased. The most you can lose on the put itself is $540. But you can sell the put at any time at the current price (before it goes to 0) and not lose the entire amount even if IBM stock does go up. Of course then you lose your insurance.
You can purchase a less expensive put, but then you’d either be giving up time, or insuring less of the move against your position.
Another factor is the pricing of puts and calls when you buy. A significant part of the pricing of an option is the Implied Volatility (IV). When “IV” is high, options tend to be more expensive, so buying options (whether they be puts or calls) is much more costly.
For this reason some option traders watch IV very carefully and tend to use buying strategies when IV is low and use selling strategies when IV is high.
The risk graph below shows the bigger picture. The amount of money you can lose on your put is limited, as indicated by the risk graph line “flat lining” at $540 (the cost of the put).
On the other hand, and this is VERY IMPORTANT, if IBM moves down dramatically, your put continues to increase in value, thereby covering a losing stock position no matter how far it may drop (as long as your put doesn’t expire and you are still able to sell the put on the exchange).
You can buy cheaper insurance. You could save ½ the premium by purchasing the put at the 80 strike price for $235. The put starts to increase in value at a much lower stock price than the 90 strike option, so it’s like having an insurance deductible. You would be financially responsible for losses from 92.41 (the current price) to approximately 80, but the put could help offset your financial losses below that.
Just like insurance, you pay a lower premium if you accept a higher deductible. Below is the risk graph for buying the April 80 put for IBM.
One thing to be aware of is that these risk graphs change as time goes on. The first risk graph of IBM above is based on the time of entry. The second and third are shown at the time of expiration. Ideally you would want to draw several lines to represent different times in the life of the option.
That’s another illustration that what I’m covering here is merely an introduction and is not a complete instruction on how to trade options. Before you trade options, take a thorough course on them and become intimately familiar with their nuances and their risks.
The illustration below shows how the IBM put with a strike price of 80 risk graph will change over time. I like to plot my risk graphs this way.
Now let’s put it all together and give you a visual presentation of how much buying a put can actually protect you.
The picture below shows a risk graph, which plots the put, and stock and the composite position you have when you buy both at the same time. This is the best picture of your real position when you buy a put to hedge your stock position. This illustration is buying the IBM put with a strike price of 80:
As you can see from the graph above, if you only owned the stock (the magenta line), you are exposed to a lot of risk as the market continues to move down. If IBM goes down to 50 (see stock price along the middle horizontal line), you are down more than $4,500.
However, by adding the put to your position, your loss would only be about $2,000.
The risk graph above was created a few days after the option chain we looked at initially. Now IBM has moved up to $98.
The price of the put with an 80 strike price is $1.70.
So you’re buying IBM at $98, and you’re buying a put with an $80 strike price. Therefore you are not buying any “insurance” until the stock gets into the range of $80 – thus giving you exposure of $18 per share. Since you’re buying 100 shares, that will give you an exposure of $1,800.
To that you must add the cost of the put you bought which was $170.
1,800 + 170 = 1,970.
Notice also that the angle of the stock line continues to move down in a straight line. That is because you will continue to lose more and more money – giving you unlimited exposure to losses until the stock goes to 0.
However the blue line, representing your profit/loss by owning both the stock and the put positions concurrently, shows that your risk in the trade flattens out just under $2,000 giving you limited exposure to the downside.
If you want less risk in the trade, you simply buy a put with a strike price closer to the current price of the stock. Of course, that more insurance will cost you more too. Instead of paying $170 for the 80 strike price put, you’ll pay $390 for the 90 strike price put.
Compare the graph above, in which a put with an $80 strike price was purchased, with the graph below in which a $90 strike price is purchased.
Strategy #2: Covered Call.
Buying a put to provide insurance against a major gap down in your stock position can be a good strategy, but as you have seen it can be expensive.
There is another protection strategy that resolves this downside. You can protect your stock position without paying any premium. In fact, you can actually get PAID to provide protection on your own stock position!
Of course anything that sounds that good is bound to have some shortcomings and it does, but first let’s look at how this very popular strategy works.
A covered call, or a “buy-write,” is a strategy in which you buy a stock and you sell a call at the same time.
You are making money because instead of buying an option, you are selling an option. So someone else is buying the option and they are paying you for it. You collect the premium rather than having to pay the premium.
Notice that you are selling a call, not a put, in this strategy.
There are several things to keep in mind:
The maximum profit of the combined position will be if the stock goes to the strike price because you receive the entire option premium and the biggest move on the stock you can get before the call goes in the money and may be exercised (the buyer of the call may decide to exercise his/her right to buy the underlying stock at the strike price). Of course if it gets close to this level, you can always buy back the calls if you choose (which will be a lot more expensive then so you will have bought high and sold low).
If the stock goes down, you are only protected by the amount of the premium you received when you sold the call.
Some of this may be difficult to follow for those new to options, so let me summarize it the upside and downside and then show some option risk graphs to illustrate the points:
Now let’s look at an example.
It’s February and you decide to buy IBM stock at 98, and you want to sell a March call with a strike price of 105 because you figure it’s unlikely that IBM will reach 105 by the third week of March, which is only about 6 weeks away. You could also sell the 110 call if you wanted more room to be right, but that would pay you less premium.
The April 105 call pays $115
The April 110 call pays $45
You decide to go with the call with the strike price of 105 for whatever reasons you may have.
We’re not talking about the right/wrong analysis in this section, only explaining how these option strategies work. Your choice of which options to buy would be based on your technical analysis.
Here’s the risk graph:
A good time to put on a covered call is when you think that market you’re trading is at the top of a cycle and is going to begin retracing. This buys you time during which the call you sold will not be exercised (providing that your analysis is correct).
Of course for everything you gain, you must sacrifice something. The sacrifice you make waiting to put on your covered call until the market begins to retrace is that you won’t have your protection in place until that time, leaving you exposed to the full risk of the stock until that time.
We’re looking at collars last because they are a combination of the first 2 strategies. You buy a put and sell a call, but you get them at different strike prices. Normally you would use options of the same expiration month, but you can play around with using different months for the put and the call. Options are very flexible!
You get the benefit of buying a put, in that you get the limited risk to the downside that the covered call does not provide.
You overcome the problem of buying the put, in that the call you sell will cover, or nearly cover, the price of buying the put.
However you still have one of the limitations of selling a call in that your upside profit potential is limited.
Below is an option chain for RIMM.
The stock is trading at 59.63 and it’s February. We could buy a March put with a strike price at 50 for $167 and we could sell a call with a strike price of 70 and collect $96. The net effect would be that the combined option position would cost us $71.
This is a fairly typical scenario with a collar. While the ultimate goal would be to have the selling of the call cover the price of the put you’re buying, it normally won’t completely cover it. Still, it serves to dramatically reduce the cost of our insurance over simply buying the put. In fact it saves us 57.5% on our insurance in this case.
If you want to get your insurance for no out of pocket cost, or even collect a premium, you can:
If you decide to buy and sell options of different months, you will need to be even more educated about implied volatility (vega) because changes in volatility can have a dramatic effect on the value of your position when you have options 2 different expiration months.
Below we look at a broader view of the same risk graph:
Since you are combining the buying of a put, with the selling of a call, it’s not surprising that the combined risk graph takes on characteristics of both.
At first glance all of these options may seem undesirable because you are giving up something in return for the “insurance.” However there is always a cost for insurance.
When you shop for homeowners, car, medical or life insurance you have choices as to:
It’s the same with buying insurance on your stock positions. There is no “best” way to do it. You choose the “policy” that fits your budget, your risk tolerance and your time horizon.
Digging Deeper Into Options
If you’re new to options, this introduction likely produced one of two results. It either scared you away from trading options or it has excited you to find out more about them. Either way, the result is good. What you don’t want to do is trade options without being fully educated in them because that is a one-way ticket to ruin. They carry high risk and you can easily lose 100% of your investment.
On the other hand, with the proper education, options can be a wonderful and rewarding way to trade, and an especially effective way to protect your positions from the occasional dramatic move against you.
Before trading options, you must learn how to read charts of the markets underlying the options.
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Barry Burns is the founder and CEO of TopDogTrading.com. He is the author of Trend Trading For Dummies.He is also a regular presenter and contributor for several exchanges, including the CME Group and Eurex, as well as the author of Top Dog Trading 5 Energy Methodology Plug-in for MetaStock.