Why Some Investors Hedge With Puts and Calls

In times of uncertainty and volatility in the market, some investors turn to hedging using puts and calls versus stock to reduce risk. Hedging is even promoted as a strategy by hedge funds, mutual funds, brokerage firms and some investment advisors.

So, in an effort to reduce risk, how would an expert efficiently hedge a portfolio of stocks?

The first step is to understand the risks of holding the portfolio of stock that you have. Options are certainly more risky to own than stock. There is a greater chance of quickly losing your investment in options compared to stocks, and the risk increases as the option gets closer to expiration or moves further out of the money (OTM).

Next, determine how much risk you want to reduce based on the understanding of the risks associated with holding the positions that you have. You may perceive that you are too concentrated in one stock and wish to reduce that risk, as well as avoid paying a capital gains tax.

Make sure you understand whatever tax rules apply to hedging so that you are not surprised after the event. These tax rules are a bit complicated but sometimes offer attractive results if managed properly. 

(Learn more about risks in Reducing Risk With Options.)

Be sure that you understand the mechanics of executing the necessary initial trades. How should you enter the trades? Should you enter market orders or limit orders or enter limit orders tied to the stock price? In my view, you should never enter market orders when trading puts or calls. Limit orders tied to the stock price are the best kind.

Next, you should understand the transaction costs involved, and that doesn't just mean the commissions. The spread between the bid and ask, the past volume and open interest should be considered before entering trades. You do not want to enter hedges where there is little or no liquidity when you want to get out.

You must also understand the margin requirements associated with the various transactions and how those requirements might change. Of course, when selling calls one-to-one against each hundred shares you own, it is simple to determine the margin requirement to make the sale (i.e. there is no margin if the stock remains in your account) even if you withdraw the proceeds upon sale of the calls. Selling more than one-to-one versus the stock gets a little more complicated, but can be handled quite easily.

(For a primer on options, refer to our Option Basics Tutorial.)

Next, you should understand the required time to monitor your positions as the stock moves around, premiums erode, volatility increases and interest rates change. You may wish to make adjustments from time to time by replacing a set of securities you are using to hedge your portfolio with a different set of securities.

Then there are the decisions about whether you should buy puts, sell calls or do a combination of the two.

Finally, decide which calls are the best to sell or which puts are the best ones to buy.

One of the most important decisions to make in options trading is when you should sell calls and buy puts. Is the best time to be selling just prior to earnings announcements when the premiums are pumped up or is the week after the earnings are announced the best time to buy puts?

Also, should you consider the implied volatility of the options hoping to sell overpriced calls and buy underpriced puts? Often, recently pumped up volatility levels imply that something may be in the works and some people are trading on inside information. Perhaps not hedging all the positions at one time is the more prudent approach.

Would you sell calls on the day the executives were granted large amounts of options or sell them two or three weeks later? Do you know how to identify what the executive insiders are doing with the securities of the prospective hedged security? There is evidence that when employee stock options and restricted stock are granted to executives, there is a much better chance the stock will increase rather than fall in the following month.

Hedging definitely has its merits, but it has to be well thought out. It is probably best to seek advice from someone experienced in this practice before trying it on your own.

(For related reading on hedging, take a look at A Beginner's Guide to Hedging.)