I’m a firm believer in adopting strong risk-management to protect your investments and hard-earned capital. While the stock markets are in a bull phase, you still need to be careful.
A strategy that I like to use to protect your investment gains is the buying of Put Options as a defensive hedge against market weakness. This strategy is called a “Protective Hedge.”
Under this scenario, investors may be somewhat bearish or uncertain and want to protect against a downside move in the stock or the market with the use of index put options. Put options can also be used as a strategy to set a lower price at which to buy the stock.
For those of you not familiar with options, a buyer of a put option contract buys the right, but not the obligation, to sell a specific number of the underlying instrument at the strike or exercise price for a specified length of time until the expiry date of the contract. After the expiry date, the particular option expires worthless and any responsibility is eliminated.
The buyer of the put option pays a premium to the writer of the option who gets compensated for assuming the risk of exercise. The writer of the put option is obligated to buy the stock from the holder of the put should it be exercised by the expiry date.
For the writer of the put option, the amount of premium received for assuming the risk is generally directly correlated to the volatility of the stock and market. The more volatile the stock, the higher the premium paid for the option. And low volatility translates into lower premiums.
You can buy puts for stocks and sectors. If your portfolio is heavy in technology, you can buy puts on the NASDAQ. Or let’s say you believe the run-up in gold and silver stocks is overvalued, you could buy put options on The Philadelphia Gold & Silver Index, which tracks 10 major gold and silver stocks.
And, similar to call options, the use of put options can also be used in special trading situations. For example, when there might be speculation that a company is set to report poor results, or perhaps on rumors of some accounting irregularities or corporate mismanagement, stocks that experience a rapid decline in their price benefit holders of put options.
Put options give the trader major leverage to make above-average returns and as a hedge against downside moves.
The strategy is straightforward and easy and inexpensive to initiate. Think about it this way: you would not avoid buying insurance for your home or expensive assets, so why not buy put options as insurance against market weakness? It’s simple and makes a whole lot of sense.