Options Hedging: Your Investment Insurance Policy
Protecting Your Portfolio from Market Risks
Hedging with options is like buying insurance for your investments. Learn how to protect your portfolio from market downturns and manage risk effectively.
What You'll Learn
- How to protect your investments from market crashes
- Different hedging strategies for various market conditions
- Real-world examples of effective hedging techniques
Part 1: Hedging Strategy Overview
Strategy 1.1: Protective Put
What It Is: Buy put options to protect stock positions
When to Use: When you want downside protection but unlimited upside
Key Points:
- Maximum Loss: Limited to cost of put option
- Maximum Gain: Unlimited upside potential minus put cost
Example:
- Own 100 AAPL at $150
- Buy $140 Put for $3
- If AAPL drops to $120, put protects below $140
- If AAPL stays above $140, lose $3 premium
Key Point: Like insurance, puts cost money but provide peace of mind
Strategy 1.2: Collar Strategy
What It Is: Buy protective put and sell covered call
When to Use: When you want low-cost or zero-cost protection
Key Points:
- Maximum Loss: Stock price - put strike + net premium
- Maximum Gain: Call strike - stock price - net premium
Example:
- Own 100 AAPL at $200
- Buy $180 Put for $5
- Sell $220 Call for $5
- Protected below $180, capped above $220
- Miss gains above $220
Key Point: Zero-cost protection by giving up some upside
Part 2: Advanced Hedging Techniques
Strategy 2.1: Delta Hedging
What It Is: Balance positive and negative deltas
When to Use: For market-neutral positions
Example:
- Long 100 shares (delta = 1.00)
- Buy 2 ATM puts (delta = -0.50 each)
- Position is now delta-neutral
- Need to adjust as delta changes
Key Point: Dynamic strategy requiring active management
Strategy 2.2: Vega Hedging
What It Is: Protect against volatility changes
When to Use: Before high-volatility events
Example:
- Long 1 ATM call (vega = 0.30)
- Short 2 OTM calls (vega = 0.15 each)
- Net vega exposure is neutral (0.30 - 2×0.15 = 0)
- Position needs adjustment as time passes
Key Point: Useful before earnings or major market events when volatility might change dramatically
Strategy 2.3: Gamma Hedging
What It Is: Protect against large price moves
When to Use: For large option positions
Example:
- Short 1 ATM straddle (negative gamma)
- Buy 2 OTM strangles (positive gamma)
- Position is now gamma neutral
- Costs money due to buying extra options
Key Point: Essential for market makers and those with large option positions
Common Hedging Mistakes to Avoid
Hedging Strategy Selection Guide
Choose Based On:
- Cost tolerance (premium willing to pay)
- Time horizon (how long need protection)
- Management style (active vs passive)
- Market outlook (volatility expectations)
Quick Decision Guide:
- Need cheap protection? → Collars
- Want full protection? → Protective puts
- Active trader? → Delta hedging
- Earnings coming? → Vega hedging