Stock Option Trading Strategies: How to Hedge Your Stock Portfolio
When investing and trading in the stock market, there are countless option trading strategies that allow you to protect your portfolio, dramatically reducing your risk.
Stock Markets globally have rallied over the last six months, however here in Australia our increasingly strong economic data and recent interest rate rise have massively increased investor confidence and this has had a follow on effect throughout global economies.
Like many savvy investors out there, if you have taken advantage of those low share prices over the last 6 months then now may just be the time to employ a protective option trading strategies that involve the use of Put Options.
A Put Option is a type of stock option contract that gives you the right to sell a parcel of shares at an agreed price, anytime before the contract expires, so they act extremely effectively as a hedge over your equities within a portfolio.
Why? you ask:
1) Because premiums are relatively cheap right now while implied volatility is low, so insuring your shares won’t cost as much. Any indication of the global economy weakening will affect insurance premiums as volatility increases.
2) Although we look strong fundamentally, what are the chances of stock prices continuing their almost vertical upward price movement? Protecting your portfolio now will give you peace of mind in the event of a market correction.
How to Hedge Your Share Portfolio
Firstly, we use option trading strategies that involve the use of Put Options. A Put Option is a type of stock option contract that gives you the right to sell a parcel of shares at an agreed price anytime before the contract expires, so they effectively act as a hedge over shares you own.
For example – if you were to buy shares for say $ 20 and you buy Put Options with $ 20 as the agreed sell price, you can sleep easy at night knowing that even if the market crashed overnight you could sell your shares tomorrow for the $ 20 you initially paid and not lose any of your hard-earned cash.
This works in almost the same way as your house or car insurance does. If your car was written off in a collision, you know the insurance company would pay for it to be replaced. And in the same way you have the choice of paying your car insurance premium monthly or annually (the choice is yours) you may choose the duration of your put protection too.
Option Trading Strategies
When implementing option trading strategies, we deal with the ASX options market and there are two different types of Put Options we may use.
Stock Options – (ETO’s or Exchange Traded Options) relate to an individual company stock or share. So if you were to buy XYZ shares at $ 20 then you would look to buy an XYZ $ 20 Put Option.
Shares that have ETO’s relating to them are called ‘optionable’ stocks and they are generally the big reliable blue-chip shares. Out of the thousands of stocks listed on the ASX, only a few hundred of them are optionable, which means that you may not be able to buy put options relating directly to some of the smaller cap stocks.
Index Options – relate to an index as a whole. Although the All Ordinaries Index is Australia’s leading indicator and represents the top 500 companies in Oz, the index itself is not optionable.
The S&P/ASX 200 Index, however, reflects the prices of the top 200 companies in Australia and it represents almost 80% of the market as a whole. The ASX 200 is optionable, so this means you can buy Index Put Options and hold a view on the whole market with one transaction.
So if the market falls in value overall, you have effectively hedged your whole equities portfolio and the index suddenly becomes more valuable and you can cash it in to cover any loss you may incur on your individual share price.