Hedging is like buying insurance for your portfolio. Options let you protect against downside risk while staying invested. Here are the main hedging strategies and when to use them.
Why Hedge?
You hedge when you want to stay invested but protect against a potential decline. Common reasons include:
- Market uncertainty or expected volatility
- Large unrealized gains you want to protect
- Concentrated positions in a single stock
- Upcoming events like elections or economic data
Key principle: Hedging has a cost. You are paying for protection. The goal is to limit losses, not to make money on the hedge itself.
Hedging Strategies
1. Protective Puts
Buy put options on stocks you own. If the stock drops, the put gains value to offset your losses.
Protective Put Example
You own 100 shares of XYZ at $100 ($10,000 value).
You buy a $95 put for $2.00 ($200 cost).
Protection: No matter how far XYZ falls, you can sell at $95.
Cost: 2% of portfolio value for this protection.
Max loss: $5 (drop to $95) + $2 (put cost) = $7 per share ($700 total)
2. Collar Strategy
Buy a protective put and sell a covered call to offset the cost. You give up some upside in exchange for cheaper protection.
Collar Example
You own 100 shares of XYZ at $100.
- Buy $95 put for $2.00
- Sell $110 call for $2.00
- Net cost: $0 (zero-cost collar)
Protection: Floor at $95, ceiling at $110.
You give up gains above $110 in exchange for free downside protection.
3. Index Hedging
Instead of hedging individual stocks, hedge with index options (SPY, QQQ, IWM).
- Cheaper than hedging each position separately
- Protects against market-wide declines
- Does not protect against individual stock risk
4. Put Spreads
Buy a put and sell a lower put to reduce hedging cost. You get partial protection at a lower price.
Put Spread Hedge Example
Portfolio value: $50,000 in SPY.
- Buy SPY $480 put for $5.00
- Sell SPY $460 put for $2.00
- Net cost: $3.00
Protection between $480 and $460 (4% protection zone).
Below $460, you are unprotected again.
How Much to Hedge
- Full hedge: Protect 100% of your portfolio. Expensive and may not be necessary.
- Partial hedge: Protect 50-75% of your portfolio. Reduces cost while providing meaningful protection.
- Tail risk hedge: Protect against extreme events only. Use far OTM puts for cheap "crash insurance."
When to Hedge
- When you cannot afford a large loss
- Before major market events
- When volatility (VIX) is low and protection is cheap
- When you have large unrealized gains
Hedging Costs
Protection is not free. Consider these costs:
- Option premium: The price you pay for puts
- Opportunity cost: With collars, you give up upside
- Time decay: Puts lose value over time if stock does not fall
Monitor Your Hedge Positions
Pro Trader Dashboard shows your hedge effectiveness and overall portfolio risk.
Summary
Hedging with options protects your portfolio against declines. Protective puts offer simple protection, collars reduce cost by giving up upside, and put spreads offer partial protection at lower cost. Hedge when you cannot afford losses or expect volatility, but remember that protection has a cost.
Learn more: put options and covered calls.