How to Hedge Stock Holdings with Stock Options

Until recently, stock options were a product left only for advanced traders. However, as time goes on and financial transactions become less expensive, even smaller investors and infrequent traders are jumping to stock options as a way to hedge their own stock holdings and lock in profits.

Locking In Profits

One method for stock option hedging is to buy either puts or calls following a serious run in price. By writing covered calls or puts, investors can take a position opposite their current pure stock position, hedging off the risk of any reversal in the market.

For example, assume you're holding 100 shares of MSFT at a buy price of $22, and the stock is currently trading for $25 per share. To lock in your profits, you purchase slightly in the money puts in the front month for less than $.50 each, hedging the downside.

Should the Microsoft stock fall from $25 per share to $24, your puts would advance $1 to $1.50 while your stock would fall to $24 from $25. The net change in your position, excluding any unknown option decay, is effectively zeroed out. For each dollar you lost in stock, you gained in options.

However, perhaps the most lucrative part of the trade is the upside that still remains. Your stock holdings have unlimited upside, and in the context of short term trading, unlimited downside. Your stock options, however, have unlimited upside and limited downside.

If the trend were to continue and the Microsoft stock were to run to $30 per share, your puts would be worthless. However, you would have logged $5 in additional profit on your stock shares. Your insurance, which are the stock options, provided full downside protection for less than 10% of the total move up. That's a profitable trade every time.

Where Hedging Can Go Wrong

Coming in at a buy price of $.50 per option means you have a gap of $.50 in your profitability. If the Microsoft stock were to rise another $.50, your stock would have risen as well, while your puts would have closed out of the money. You would have, in this instance, broken even, and erased some of your upside.

The Golden Ratio

Never mind Fibonacci retracements; in the land of stock option hedging, it is best to look for paired stock and stock options that allow you to hedge for a price that is one-tenth or less of your expected upside. While these trades are few and far between, the 10% rule is a number designed to ensure profitability on every trade and every strategy, even short term, highly leveraged plays.

Remember, just as you wouldn't buy life insurance if it cost $10,000 per month, you shouldn't buy stock insurance if it costs too much, either. While stock options are an excellent way to leverage up, or hedge a position down, they are just as much a play on full market volatility. If you can grab insurance inexpensively on a high beta name in a low VIX market, by all means, do so. However, never pay too much on short term protection, otherwise you risk losing a money on a trade due only to your own prudence.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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