Lesson 3: Basic Hedging with Options

What is Hedging?

Hedging is using financial instruments to reduce or eliminate the risk of adverse price movements in an asset. Think of it as insurance for your investments.

Why Hedge with Options?

• Portfolio Protection: Limit downside risk
• Cost-Effective: Cheaper than selling positions
• Flexible: Can be tailored to specific risk levels
• Temporary: Can be removed when risk diminishes

Hedging Individual Stock Positions

1. Protective Put (As Insurance)

• Situation: Own stock, concerned about short-term decline
• Strategy: Buy puts for downside protection
• Cost: Premium paid (like insurance premium)
• Decision: How much protection vs. cost?

Choosing the Right Put:

• ATM puts: Maximum protection, highest cost
• OTM puts: Cheaper, less protection
• Expiration: Match to expected risk period

2. Collar Strategy

• Objective: Protect gains with zero or low cost
• Setup: Own stock + Buy put + Sell call
• Result: Limited upside, protected downside
• Cost: Often zero-cost (call premium covers put cost)

Example:

• Own XYZ at $50, now trading at $60
• Buy XYZ 55 put for $2
• Sell XYZ 65 call for $2
• Result: Protected below $55, capped at $65, zero cost

Hedging Portfolio Risk

1. Index Put Options

• Situation: Concerned about broad market decline
• Strategy: Buy puts on SPY (S&P 500 ETF) or similar index
• Benefit: Protects diversified portfolio
• Calculation: Determine hedge ratio based on portfolio beta

2. Put Spreads for Cost Efficiency

• Situation: Want protection but lower cost
• Strategy: Buy ATM put + Sell OTM put (put debit spread)
• Result: Limited protection, lower cost
• Trade-off: Protection only within a range

Hedging Specific Risks

Earnings Announcements

• Risk: Stock gaps up or down after earnings
• Strategy: Long straddle or strangle
• Timing: Buy before earnings, sell after

Merger Arbitrage

• Risk: Deal falls through
• Strategy: Buy puts on acquisition target
• Protection: Limits loss if deal collapses

Sector-Specific Risks

• Risk: Sector downturn
• Strategy: Buy puts on sector ETF
• Example: Tech sector concern → Buy puts on XLK

Hedge Ratios and Portfolio Beta

Calculating How Much to Hedge:

1. Determine portfolio beta (measure of market sensitivity)
2. Calculate equivalent market exposure
3. Select appropriate option quantity

Formula:
Number of index puts needed = (Portfolio Value × Portfolio Beta) ÷ (Index Value × 100)

Example:

• $100,000 portfolio, beta 1.2
• SPY trading at $400
• Puts needed: ($100,000 × 1.2) ÷ ($400 × 100) = 3 contracts

Cost of Hedging

Factors Affecting Hedge Cost:

1. Volatility: Higher volatility = more expensive
2. Time to Expiration: Longer time = more expensive
3. Protection Level: Deeper protection = more expensive

Managing Hedge Costs:

• Use spreads instead of outright positions
• Hedge only during high-risk periods
• Consider alternative strategies (inverse ETFs, etc.)

Practical Exercise

You own a $50,000 portfolio with beta of 0.8. You’re concerned about a market correction over the next 3 months.

1. Calculate how many SPY put options you’d need to hedge
2. Research current SPY put prices for 3-month expiration
3. Calculate the cost of hedging and what percentage of portfolio that represents