Although stocks offer high returns, they are also highly risky. Making an incorrect forecast on the direction a stock will take (bullish or bearish) can result in significant losses.
However, a good understanding of stock options trading strategies can help you hedge your portfolio and minimize losses.
What is hedging with options?
Though options are popular among retail traders as a way to earn income or speculate about market directions, they are also a powerful risk management tool.
Hedging is a risk management strategy that protects you from or minimizes potential losses if the market goes against you.
Options are a powerful hedging tool that fund managers have traditionally used. However, their importance is not limited to sophisticated traders; even you, as a retail trader, can benefit from them.
Three practical hedging strategies
There are three levels of options trading strategies: Level 1, 2, and 3. Only Level 2 and 3 can be used for hedging.
However, Level 3 strategies are very complex, and non-sophisticated traders may have their hands burned by using them. Thus, we will focus on Level 2 strategies below:
Covered call
A covered call is a strategy where you hold a long position on a stock and also sell a call option on it.
By going long on the stock, you expect its price to go up (you are bullish). However, there is a possibility that the stock goes down, and you lose money.
To minimize the potential losses, you sell a call option. Selling a call option means you must sell the underlying stock to the option buyer once they choose to exercise the option.
Suppose this is a call option on NVDA with a strike price of $150 and a premium of $5 per share, which expires on July 1.
If the price rises to $200 in the spot market, they can buy it from you for $150 instead of $200.
As long as you purchased the stock for less than $150, you would still make a profit when you sell it for $150. Also, you get to receive a premium of $10 per share.
On the other hand, if the share price falls to $120, the option buyer will not exercise it, and you get to keep both your stock and the premium you have received.
Cash-secured put
A cash-secured put is an options strategy where you sell a put option and also have enough money in your account to buy the stock if the option buyer decides to exercise it.
Suppose this is a put option for AAPL with a strike price of $200 and a premium of $5 per share, which expires on July 1.
If the spot price of AAPL falls to $180, it makes sense to sell at the strike price rather than the spot price. In this case, you will have to buy the stock at $200 from the buyer, while keeping the premium received.
On the other hand, if the spot price rises to $220, the buyer will not exercise the option, and you get to keep the premium and the cash.
This is a good strategy if you are mildly bullish on a stock you would ordinarily love to own. If the market ends up bearish, the worst thing that will happen is that you will now own the stock.
Married or protective put
This is a strategy where a trader who owns a stock also purchases a put option on it.
Let’s continue with the previous example, but now you are the option buyer.
If the price falls to $180, you can sell at $200 (the strike price) and profit from the stock you already own.
On the other hand, if the price rises to $220, you will not exercise the option. You get to keep the stock or sell it for a higher price in the spot market, while losing only the premium paid.
Why portfolio hedging with options matters
As seen above, hedging with options has the following advantages:
- Helps you make a profit irrespective of market conditions: With options, you can make money whether the market ends up bullish or bearish.
- Minimize your losses when the market is against you: Options can help limit the potential losses of an option buyer to just the premium paid.
- Helps you stay invested while reducing risk: Options can help you hold on to your stock positions if you don’t want to close them.
If you are learning how to make money online in the UAE through stocks and ETFs, you will benefit from hedging your positions with stock options.
Sarwa is a trading platform that makes it easy for you to buy and sell both call and put options on all your favorite US stocks and ETFs. With competitive commissions, comparison charts, bank-level SSL security, free transfers, and an intuitive platform, they make options trading simple, cost-effective, and safe.
If you are ready to enjoy the benefits of hedging with options, sign up with Sarwa and start trading stock options.
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