How to Use Options for Hedging

I’ve talked about using leverage or options for leverage, as well as the risks of that. Well, in this post, I want to go over how to use options for hedging.

What is Hedging?

Instead of selling stocks when you’re anticipating a pull back in the market or your headed off on vacation, you could but a few protective puts or spreads. That’s the basic premise of hedging.

You can also hedge out a temporary news headline. Maybe you don’t want to sell your stocks over whatever the news might be, or maybe it’s a major geopolitical uncertainty or whatever.

What I think is important is to understand that a hedge is, in my opinion, it is not a trade.

What does that mean?

Well, a lot of people will say, “Let’s buy some puts here in the S&P 500, because I think the market’s going to go down.” They might think that’s a hedge, but they treat it more as a trade.

As soon as you start merging those two ideas, you start completely missing the point of the hedge which is to ride your portfolio through the uncertainty. It’s not to make a quick buck on an uncertain event.

An Example of Hedging

One of the instruments I like to use for U.S. equity exposure for the most part is either the S&P 500, the SPY ETF, the Russell 2000, or even the NASDAQ 100 ETF.

Let’s assume you have a portfolio that’s made up of a whole bunch of stocks, that’s kind of all over the place. What I’d like to do, I’ll probably just buy some puts or put spreads in the S&P 500. I’ll use options that expire at least a month or two months out in the future, so right now it’s mid-June 2018, and I would probably look to at least use August options.

Again, because I’m not trying to do a trade for immediate gratification, what I’m trying to do is  I’m trying to do a trade to hedge my portfolio. So I’m looking to use the monthly options, using August.

In my example, right now the S&P 500 is trading with the SPY ETF and is trading around 278. I’d probably just literally go ahead and use a 278 strike August puts, or a put spread. Meaning, I would look to see if I think the S&P’s going to drop, say, a percent or two. I would then use the lower strike than what I’m going to sell against the strike I’m putting as the one I’m selling.

What happens if your portfolio is a little bit more concentrated in a different area? So maybe your portfolio is much more technology heavy. Maybe all you own in your portfolio is Apple and Google and Netflix. But let’s assume that’s the case.

Well, then you don’t necessarily need to use the S&P. Maybe then you use something like the NASDAQ 100 to hedge out some risks. What if your portfolio’s more small-cap oriented? Then maybe you want to use the Russell 2000.

Final Thoughts

I would say the two main takeaways here are number one, don’t use a hedge as a trade. Because a lot of times, what’s going to happen if you use the hedge as a trade or if you start thinking of it as a trade, you’ll tend to exit too early, and forget about the whole situation.

I’m a big fan of using this strategy, but a lot of people once they get into the hedging business, start overthinking things. I think it’s important to keep it simple and clean, either by a put or a put spread.

Also, make sure you don’t do it too often because there’s always some reason to be afraid of something every day, right? So make sure you really use it sparingly. The other way of hedging is just to reduce your portfolio size, or reduce certain things in your portfolio.

I think hedging is a great thing to do. Again, make sure you use it only in situations where there is actual risk out there. A lot of times you can kind of look at the VIX for example to see what the anticipated risk in the market is. So the VIX at 12 doesn’t really spell a lot of fear.