Hedge Strategy Overview

hedge strategy - portfolio protection with options

The most conservative use of options is to use them as a hedge strategy to protect your portfolio (or portions of it). You insure your property and other valuable possessions. Why wouldn't you extend that protection to your brokerage account as well?

Insuring your stock investments is no different from insuring your car or your home. The better your coverage, the more expensive the premium. But in the world of investing, good protection can be a real drag on your returns.

The Case for Hedging

There are still good cases to be made for the selective use of a hedging strategy, however.

For instance, the options premium on less volatile stocks, by definition, will be a lot less than the premium on high-flying growth stocks. If you own high growth stocks, presumably you've got the consitution to endure wild price swings in the short term. But if your blue chip core holding drops 30-40-50% due to some unforeseen event you may be waiting a long while for that stock to come back.

It might make more sense then to buy insurance for the unexpected (an unforeseen calamity to your blue chip core holding) than paying top dollar to protect against what is essentially an expected event (dramatic price swings in your growth stock known for dramatic price swings).

Additionally, if you have a substantial portfolio where preservation of capital trumps aggressive growth or total returns, you'll definitely want to adopt some kind of hedge strategy to protect your holdings. Pension funds, for example, are big users of hedging strategies.

Another sensible use of a hedge strategy is to protect a position following a big rally in the stock. If you believe that the rally is unsustainable, but you prefer to hold on to the position rather than sell it, it very well might be worth your while to hedge the position and protect your gains. For that matter, any time you believe strongly that your long term holding will be heading lower is the right time for a hedging strategy.

Also, depending on a variety of factors, if you're willing to forego upside potential on your stock in the near term, you can, in effect, acquire very cheap, and sometimes no cost, insurance through the use of options.

Hedging Strategies Detailed

It's important to note that stock option hedging is not a single or simple strategy. This section of the website features techniques with primarily hedge strategy objectives.

But hedging is a component that can be, and usually is to some degree, part of all option trades. Recall that stock options trading is primarily the trading of risk. The options trader is always factoring in and adjusting risk, and risk is a spectrum, not a switch.

Having said that, below are some specific option trading strategies focusing primarily on hedging: