I love trading options…
There is no other instrument I’ve found that can give you the type of fast and steady returns they do.
For example, here are two trades I had from last week that would be life-changing for most folks:
And…
Sure, speculating with options can be awesome. But you could also use options as a hedging tool too.
If you have a long-term stock position and are interested in ways in protecting it, then listen up because I’m going to show you three ways you can hedge to bulletproof your position, lock in gains or protect yourself from further losses.
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How to Manage Your Risk With Options
Let’s face it when you’re long stocks… you’re exposed to a lot of risks, such as company-specific and market-related news.
If you buy stocks… you’ve probably thought, What happens if the stock moves against me? Should I put a stop? How can I hedge my risk?
You see, many traders want to stay long a stock… but can’t take the pain on pullbacks.
This is where options come into play.
If you don’t know, if you’re long stock… you can actually hedge your position and take part in a move higher and generate some profits while limiting your downside risk.
How?
Well, there are a few ways to do that: buy puts, sell calls, or use the collar strategy.
Easiest Way to Hedge Your Stock Position
Now, the easiest way to hedge your long stock position would be to buy put options.
Here’s a look at the profit and loss (PnL) chart of a long stock position.
Basically, when the stock moves against you… you’ll have losses… and your losses are capped but could be really high.
For example, what happens if the stock releases earnings and provides weaker-than-expected guidance, causing the stock to plummet?
You could lose a whole lot more than you’d expect
Now, if you’re afraid the stock might crash, but think it’ll go back up at some point… you can actually buy puts to hedge your risk.
Here’s a look at what happens when you buy a put option when you’re long stock. This strategy is known as the married put or protective put.
Your PnL chart changes to the one shown above and it’s the same risk profile as a long call. Basically, your max loss is capped now. When you buy a put option, your max loss is just the premium paid (and commissions) for those put options.
Now, your breakeven point is the price at which you bought the stock plus the premium paid for the put options… and you can still take part in the move higher.
Another way you can hedge your stock position would be to sell calls.
Selling Calls Against Your Long Stock Position
Selling calls against your long stock position is a little different from buying puts. Basically, when you sell a call option, you’re obligated to sell shares if the option is deep in the money and you get shares assigned.
Now, traders actually use this strategy when they’ve seen some nice gains on a stock. Basically, it’s a way for them to still take part in a move higher, but are satisfied with their gains.
When you’re long stock and sell calls, the strategy is known as a covered call.
How do you use this strategy?
Well, let’s say you’re long a stock at $50 a share and it’s currently trading at $60… you think the stock could run higher and are willing to sell at a specific level, let’s say $65.
What you could do here is sell calls at $65 since you’re willing to sell your shares at that level.
If you’re long stock and sell calls at $65, here’s how your PnL chart will look like.
Now, it all depends on your objective here… if you want to sell your shares at $65… then you want the stock to rise above the strike price… and stay above at the expiration date. That way, when the shares expire in the money, you would be assigned and automatically sell your shares at $65.
On the other hand, if you’re selling calls to earn income on your stock position… you want the stock to be as close to the strike price ($65), but not break above that level.
As you can see, you still have downside risk here (if the stock pulls back and gets below $50, you would lose money on the long stock position, but collect the premium for the short calls).
That said, it may be safer to only employ this strategy when you’re sitting in profits and want to sell your shares at a specific level.
Last, but not least, you can use the collar strategy to hedge your stock position (this caps your downside and upside).
Using the Collar Strategy as a Hedge
Let’s say you’re long shares of a stock… you’re bullish but are nervous.
Well, you can actually use a combination of the first two ways to hedge: sell calls and buy puts. When you do that… you actually create a “collar”.
Basically, you buy a put that’s below the price at which you bought the stock… and sell calls with a strike price above your entry price.
Now, some traders actually like to use this strategy because you don’t have to pay a whole lot of premium. You see, when you sell calls you collect premium, and that helps pay for the put options.
However, this caps your upside, as well as your downside. If you’re running this strategy, you should be willing to sell your shares at a specific price.
Here’s how the PnL chart looks for the collar strategy. If you know anything about options, this risk profile is similar to that of a call spread.
Let’s say you’re long shares at $52, and want to sell those shares at $60… you’re bullish, but think the stock could go against you.
Well, you could buy put options with a strike price at $50… and sell calls at $60. That said, you want the stock to stay above $60 on the expiration date, so you would automatically sell those shares.
As you can see options can be very powerful and there are countless ways to hedge your long stock position. Now, I don’t buy stocks a whole lot… options are my weapon of choice and I typically don’t have to worry about hedging my stock-specific positions.
If you want to start trading options, whether it be for hedging purposes or trying to knock down triple-digit winners, then you’ll want to check out this free ebook. It’s my newest trading approach that leverages some of Wall Street’s best’ kept strategy. Click here to get started.
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