With major indices having entered the 10% correction territory many people are wondering if they should consider using options to hedge or protect their portfolios in case this turns into a full blown bear market. 

Steve is here to provide some suggestions on the do’s, don’ts and the when and how. 

The first thing to be aware of is the decision to use options to hedge or protect against downside is in fact  a trading decision. 

For it to be truly effective, and not just a costly form of buying peace of mind you need to be making a market call.  Not only a belief stocks have further to fall but also by how much; meaning the hedge won’t work if you don’t have a target for when and where you would exit to reap the benefits of the protection.

In this sense you are simply making a bearish trade.

For most people with a diversified portfolio with a long term horizon the answer to whether to hedge is; don’t do it!

How Much Protection & For How Long?

Straight up buying put options does offer the most complete and way to hedge a position, but it is also the most expensive. And that cost, as with all insurance policies, will be a function of the amount of protection and its duration.

The main items to consider when choosing put protection — whether for an individual stock or a broad equity portfolio — are:

1. What magnitude of a decline is expected?

2. At what level of the decline do you want the position to be fully hedged or protected?

3. For what length of time do you want the protection in place?

Spread Instead

While you’ll still have to answer the questions above, a basic vertical spread, in which you buy a put and sell a lower strike put with the same expiration date, will cost significantly less than buying a put outright. 

For example a trade I’m establishing in SPY, and note I view this as a trade, not a hedge, is to:

-Buy the May (5/16) 555 Puts

-Sell the May (5/16) 540 Puts

For a Net Debit of $5.00

Some things to note about this spread:

• With SPY currently trading around $556 this spread will begin to move into-the-mone on any further decline. 

• The time frame includes the next earnings period; one in which we’ll see if the current warnings and concerns over tariffs and a weakening consumer come to fruition. 

• It targets the support level around $535, which would place it fully in-the-money

• If it is fully in-the-money at expiration it delivers 3x profit or $1500 for every $500 at risk. 

• I’ll consider this a  “set it and forget” position silently sitting in the background. 

Now I can block out the background noise about how much lower we can go and focus on my active trading.  

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