How to Use Index Options to Hedge – Schaeffers Research (blog)

Options can not only be used to speculate on a stock’s direction, but also as portfolio insurance. A shareholder who is nervous about a pullback might buy a protective put or “married put” on a stock they own, to use as an insurance policy, in a way. Likewise, traders can also hedge their portfolios more broadly by purchasing puts on index-based exchange-traded funds (ETFs) like the SPDR S&P 500 ETF Trust (SPY)

Building a Background for ETFs 

Exchange-traded funds trade just like stocks, but they offer exposure to a wide array of related stocks and securities. As far as liquidity, ETFs are better than the indexes they’re based on (more option volume equals more favorable entry and exit prices), and some index options are less-flexible European-style exercise, whereas ETF options are more commonly Americanized.

There are thousands of ETFs that focus on specific sectors, like the Financial Select Sector SPDR Fund (XLF) for bank stocks, the PowerShares QQQ Trust ETF (QQQ) for tech, or the Guggenheim Solar ETF (TAN) for solar stocks. The SPY goes hand-in-hand with the broader S&P 500 Index (SPX), but trades at a fraction of the cost.

Buying a Protective Put on SPY

Buying a protective put on SPY is similar to buying a protective put on a stock. When an investor remains bullish on a stock’s long-term prospects for the company, but would like to remain cautious, he or she could purchase a protective put on that stock. A protective put on SPY would allow the trader to hedge against a broad-market pullback. In this event, the gains in the long SPY put would help to offset potential portfolio losses.

Affiliated Risks with Protected Puts

As with any ETF hedge, you’re not necessarily going to get a perfect inverse correlation between your stock losses and your put-related profits. In any case, risk is limited to the initial premium paid for the put contract. So, if the SPY rallies over the course of the option’s lifetime, the protective put buyer will lose the initial premium paid, but his or her stock portfolio will likely continue to make money.

And remember, as with any insurance policy — the holder isn’t hoping for disaster. The SPY protective put buyer sill wants the stock market to do well, but buying the put helps him or her sleep a little better at night.

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