How To Use Put Options as a Hedging Strategy

Reviewed by Charles PottersFact checked by Jiwon MaReviewed by Charles PottersFact checked by Jiwon Ma

Investors use hedging strategies to cut their exposure to risk in case an asset in their portfolio has a sudden price decline. When done correctly, hedging strategies reduce uncertainty and limit losses without significantly decreasing your rate of return.

Usually, investors buy securities that are inversely correlated with a vulnerable asset in their portfolio. Should the price decrease, the inversely correlated security should move in the opposite direction, acting as a hedge against losses. Some investors also buy financial instruments called derivatives. When used strategically, they can limit investors’ losses to a preset amount.

A put option on a stock or index is a classic hedging instrument that provides downside protection. Read on to see how put options might help you to minimize potential losses.

Key Takeaways

• A hedge is an investment that protects your portfolio from adverse price movements.
• Put options give investors the right to sell an asset at a specific price within a preset time frame.
• Investors can buy put options as a form of downside protection for their long positions.
• The pricing of options is determined by their downside risk, which is the likelihood that the stock or index that they are hedging will lose value if there is a change in market conditions.
• Options tend to be cheaper the further they are from expiration, and the further away they are from the money.

How Put Options Work

With a put option, you can sell a stock at a specific price within a given time frame. For example, suppose you buy a stock at $14 per share. You expect the price to go up, but if the stock value plummets, you can pay a small fee (say, $7) to guarantee you can exercise the put option and sell the stock at $10 within one year.

Now, in six months, should the value of the stock have increased to $16, you wouldn’t exercise the put option, so you’ll have lost the $7. However, if in six months the value of the stock fell to $8, you can sell the stock for $10 per share. With the put option, you would thus limit your losses to $4 per share. This is one of the reasons options have become so popular among all kinds of investors.

How Downside Risk Determines Option Prices

The pricing of derivatives is related to the downside risk in the underlying security. This risk estimates the likelihood of the underlying asset’s value decreasing should market conditions change. When investors determine there’s greater downside risk, they’re willing to pay more for put options as protection. This increased demand drives up option premiums. Conversely, when downside risk is seen as low, put option prices tend to be cheaper.

Several factors contribute to the market’s assessment of downside risk. Economic indicators, company-specific news, geopolitical events, and overall market sentiment all play a role. For instance, during periods of economic uncertainty or market volatility, put option prices often rise as investors seek to protect their portfolios against potential losses.

The Black-Scholes model, a widely used option pricing formula, incorporates volatility as a major input. Higher implied volatility, which is associated with greater downside risk, results in higher option prices. Thus, put options on more volatile stocks or during turbulent market conditions tend to be more expensive.

By purchasing a put option, an investor is transferring the downside risk to the seller. In general, the more downside risk the purchaser of the hedge seeks to transfer to the seller, the more expensive the hedge will be.

Note

Call options give investors the right to buy the underlying security; put options give investors the right to sell it.

Importance of the Expiration Date and Strike Price

Once an investor has chosen a stock for an options trade, there are two critical considerations: the time frame until the option expires and the strike price. The strike price is the cost for exercising the option.

Expiration Date

The expiration date determines how long the hedge will stay in effect. Longer-dated options typically offer more protection but at a higher cost. They give you more time for market conditions to change and for the option to become more profitable. However, they also experience slower time decay, meaning they retain value longer.

Meanwhile, shorter-dated options are usually cheaper but offer less time. They experience faster time decay, which can be helpful if you’re selling options but unfavorable if you’re buying them for protection. You’ll have to balance the hedging protection you need against these different costs.

Strike Price

The strike price is the preset cost for exercising the option. When put options are used as hedges, the strike price represents the level of protection. A strike price closer to the present market price (at-the-money) protects you more but is more expensive. Out-of-the-money puts (with strike prices below the current market price) are cheaper but only protect against more significant market declines.

Options with higher strike prices are more expensive because the seller is taking on more risk. However, options with higher strike prices provide more price protection for the purchaser.

Ideally, the purchase price of the put option would be exactly equal to the expected downside risk of the underlying security. This would be a perfectly-priced hedge. However, if this were the case, there would be little reason not to hedge every investment.

7%

The percentage of options that are exercised, according to the Financial Industry Regulatory Authority. The rest expire worthless or are closed out before expiration.

Risks and Costs of Put Options

Of course, the market is nowhere near that efficient, precise, or generous. There are three critical factors in the cost of any options strategy:

1. Volatility premium: Implied volatility is usually higher than realized volatility for most securities. The reason for this is open to debate, but the result is that investors regularly overpay for downside protection.
2. Skew: Stock prices have a tendency to move upward over time. As the value of the underlying security gradually increases, the value of the put option gradually declines.
3. Time Decay: Like all long option positions, each day an option moves closer to its expiration date, it loses some of its value. The rate of decay increases as the time left on the option decreases.

Because higher strike prices make for more expensive put options, the challenge for investors is to only buy as much protection as they need. This generally means purchasing put options at lower strike prices and thus assuming more of the security’s downside risk.

Put Spreads

Investors are often more concerned with hedging against moderate price declines than severe declines, since such price drops are both very unpredictable and relatively common. For these investors, a bear put spread can be a cost-effective hedging strategy.

In a bear put spread, the investor buys a put with a higher strike price and also sells one with a lower strike price with the same expiration date. This provides limited protection because the maximum payout is the difference between the two strike prices. However, this is often enough protection to handle either a mild or moderate downturn.

A major advantage of a put spread is its cost-effectiveness. Rather than simply buying a put option outright, which would be more expensive, the bear put spread reduces the net premium by including the sale of the lower strike put. This makes it a more accessible strategy for investors who want to hedge against downside risk without overcommitting financial resources to insurance against worst-case scenarios.

A more complex variant is the ratio put spread, where the investor buys a certain number of put options at one strike price and simultaneously sells a higher number of puts at a lower strike price. This strategy can generate higher premiums and is often used in slightly bearish market conditions where the investor anticipates a moderate decline.

However, the risk increases if the market experiences a significant downturn since more puts will likely be sold than bought, potentially leading to substantial losses. Other variations on put spreads include diagonal spreads, which involve buying and selling put options with different strike prices and expiration dates.

Calendar Spreads

Adding extra months to a put option gets cheaper the more times you extend the expiration date. This hedging strategy is a chance to use what are called calendar spreads. These are created by purchasing a long-term put option and selling a short-term put option at the same strike price.

However, this practice doesn’t decrease the investor’s short-term downside risk. If the stock price declines significantly in the coming months, the investor may face some difficult decisions. They must decide if they want to exercise the long-term put option, losing its remaining time value, or if they want to buy back the shorter put option and risk tying up even more money in a losing position.

In favorable circumstances, a calendar spread results in a cheap, long-term hedge that can be rolled forward indefinitely. However, without adequate research, the investor may inadvertently introduce new risks into their investment portfolio with this strategy.

Put LEAPS: Long-Term Put Options

Another way to get the most value out of a hedge is to buy a long-term put option or the put option with the longest expiration date. A six-month put option isn’t always twice the price of a three-month put option, and a one-year option isn’t always twice as much as one expiring in six months. When purchasing an option, the marginal cost of each additional month is often lower than the last. Still, a one-year option will involve a higher upfront cost than a nearer-term option.

Long-term equity anticipation securities (LEAPS) are options with expiration dates that extend beyond one year, providing investors with long-term protection and strategic flexibility. Investors concerned with the unpredictability and frequency of market downturns might find LEAPS particularly worthwhile.

Unlike shorter-term options, LEAPS allow investors to hedge their positions over an extended period without frequently rolling over positions as expiration dates approach. This can be especially advantageous during periods of market volatility when predicting the timing of a downturn is challenging.

Cost-Effectiveness of Long-Term Puts

When hedging with a put option, following a two-step approach is usually best. First, determine what level of risk is acceptable. Next, identify what transactions can cost-effectively mitigate this risk.

As a rule, long-term put options with a low strike price provide the best hedging value. This is because their cost per market day can be very low. Although initially expensive, they are helpful for long-term investments. Long-term put options can be rolled forward to extend the expiration date, ensuring that a good hedge is always in place.

Of course, some investments are easier to hedge than others. Put options for broad indexes are cheaper than individual stocks because they have lower volatility.

It’s important to note that put options only help eliminate risk if there’s a sudden price decline. Hedging strategies should always be combined with other portfolio management techniques like diversification, rebalancing, and a rigorous process for analyzing and selecting securities.

Example Using a Long-Term Put Option

Suppose an investor holds a position of 100 shares of Tesla, Inc. (TSLA) stock and is concerned about potential downside risks over the next 12 months because of volatility and company-specific risks. To protect against a large decline in TSLA’s stock price, the investor could buy a one-year LEAP put.

The investor buys a put option with an expiration date 12 months from now and an out-of-the-money strike price of $200. This lower strike price is chosen as it provides a reasonable level of protection while keeping the premium costs manageable.

• Current TSLA share price: $220
• Investment size: 100 shares x $220 = $22,000
• Strike Price: $200
• Expiration: 12 months from today
• Premium: $25 per share (total cost: $2,500 for one contract, which covers 100 shares)

Possible Outcomes

TSLA Declines Significantly

• If TSLA’s stock price drops to $150 at expiration, the LEAPS put option will be in the money.
• The investor can sell the TSLA shares at the $200 strike price, limiting the loss effectively to $20 per share, less the cost of the option.
• Without the put, the investor would face a loss of $7,000 ($70 decline per share on 100 shares).
• With the LEAPS put, the maximum loss is limited to the $2,500 premium plus the $2,000 difference between the strike price and the current price, resulting in a total effective loss of $4,500. This is a much smaller loss than without the put option.

TSLA Price Remains Stable or Increases

• If TSLA’s stock price remains above $200 or increases, the put option will expire worthless.
• The investor’s loss is limited to the $2,500 premium paid for the LEAPS put.
• However, the investor still benefits from any upside in TSLA’s stock price minus the cost of the put option.

By purchasing the LEAPS option, the investor has secured downside protection for their TSLA position over the next 12 months. This protection costs the option premium ($2,500) but offers significant peace of mind.

How Do You Hedge Stocks With Options?

Options allow investors to hedge their positions against adverse price movements. If an investor has a substantial long position on a certain stock, they may buy put options as a form of downside protection. If the stock price falls, the put option allows the investor to sell the stock at a higher price than the spot market, thereby allowing them to recoup their losses.

What Is Delta in Options Trading?

In options trading, delta is a risk metric that estimates the expected change of an options price based on the predicted change of the underlying asset. For example, a call option with a delta of +0.65 will have a 65% change in value if the price underlying security increases by $1. The delta of a call option is always greater than or equal to zero. For put options, the delta is less than or equal to zero.

How Much Do Options Traders Make?

An options trader in the U.S. earns an average salary of $112,000 per year, according to ZipRecruiter. This is before adding in any performance-related bonuses or incentives.

The Bottom Line

Put options can be an excellent way to manage risk in your portfolio. These financial instruments give the holder the right, but not the obligation, to sell an underlying asset at a preset price (strike price) before a specific date (expiration date). By purchasing put options, investors can establish a price floor for their investments, limiting potential losses while maintaining the chance for upside gains. This hedging strategy is particularly valuable during market uncertainty or when investors want to safeguard against short-term volatility without liquidating their positions.

The effectiveness of put options as hedges depends on selecting the right strike price, the expiration date, and your risk tolerance and market outlook. While put options can provide valuable protection, they come at a cost—the option premium—which is the maximum loss if the option expires worthless. Investors must carefully balance the desired level of protection against the cost of executing the hedge.

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