Retail investors often utilize options as a method of placing high-risk, short-term bets on stocks. However, they can be a very effective tool for both protecting an investor’s portfolio as well as a low-risk method for enhancing returns. “The original intention of options was to provide investors with portfolio hedging and management options,” notes Ryan Maxwell, CEO of FirstRate Data, a financial data provider.
Understanding Protective Put Options
The most common and straightforward way to use options for portfolio protection is through a strategy known as a protective put. This approach involves buying put options on stocks an investor already owns or options on a broader index if the investor owns multiple stocks.
How Protective Puts Work
A put option gives you the right, but not the obligation, to sell a stock at a specific price (the strike price) within a certain timeframe. By purchasing a put option, you’re essentially buying insurance against a significant drop in your stock’s value.
For example, let’s say an investor owns 100 shares of AAPL stock, trading at $230 per share. If the investor is concerned about upcoming market volatility, the investor could purchase a put option with a strike price of $220, expiring in three months. If the stock price falls below $220 before expiration, you have the right to sell your shares at $220, limiting your potential loss to the $10 price decline plus the cost of the option.
A protective put can function similarly to a stop-loss order, which is a pre-set price limit at which the brokerage will automatically sell the stock. However, there are several crucial differences. Most importantly, a stop-loss will close out an investor’s position in the stock, and the investor will not benefit from any price rebound unless a separate buy order is placed.
It should be noted that the premium paid for the option reduces your overall return if the stock price doesn’t fall. Also, puts have an expiration date, so you must repurchase protection periodically if you want ongoing coverage.
Portfolio-Wide Protection Strategies
While you can buy puts on individual stocks, protecting your entire portfolio using index options is often more efficient.
If your portfolio closely tracks a major index like the S&P 500, you can buy put options on an ETF that mirrors that index, such as the SPDR S&P 500 ETF (SPY). This approach provides broad protection against market-wide declines.
To determine how many put options to buy, you’ll need to calculate the number of contracts that correspond to your portfolio’s value. For example, if your $500,000 portfolio closely tracks the S&P 500, and the SPY is trading at $400, you would need approximately 13 contracts (($500,000 / $400) / 100 shares per contract).
Covered Call Strategies
In addition to providing portfolio protection, options can also be used to enhance the return of a portfolio without taking on additional risk. A ‘covered call’ strategy involves selling (‘writing’) a call option on stock an investor already holds. For example, if an investor held 100 shares of META currently trading at $530, they could sell a call option on 100 META shares at a strike price of $580 for a premium of $6.
Thus, the investor would enjoy the upside in the stock from $530 to $580, after which there would be no upside as the options would be exercised, and the stock would be ‘called.’ In return for forfeiting the returns above $580, the investor would receive $600 in income from the option premium. Essentially, this conservative strategy is best suited to situations where the investor expects the market to post modest gains. This strategy is sometimes used to fund the purchase of the protective put, in which case the investor is forfeiting some upside in return for protecting the downside in the portfolio.
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