How Stock Investors Can Hedge against Severe Losses

James DiGeorgia

Knowing when to sell may be the most difficult part of investing. This is because the two most significant factors that drive the markets are greed and fear.

When stocks are flying, our natural inclination is to hang on and hope for more. When they fall, we sell the shares out of fear — often forgetting about the long-term reasons we bought them in the first place.

It’s strange, really. Generally investors are afraid to take profits, yet quick to take losses. Unfortunately, this is not a very good formula for making money!

Now, I’m not advocating short-term trading if that’s not your preferred money-making strategy. After all, the stock market has a very long history of upward bias.

The thing is, statistically speaking, you may just be better off buying and holding. But the emotional side of investors rarely allows this strategy to work.

And so … the roller coaster starts, your profits become losses, and there you are selling at a loss again.

Is There a Better Way to Trade?

In certain circumstances, you may want to consider portfolio insurance. This means adding an asset to your portfolio that will increase in value as a particular stock or index falls in value. Financial professionals call this a hedge.

Today, I’m going to share with you the many ways you can place a hedge in your portfolio.

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To understand hedging, you need to understand some basics of the options markets, one of the primary tools used for hedging.

Options are a way for investors to buy and sell risk. While this may seem unusual, it actually occurs in many ways in our everyday lives.

For example, driving a car involves the risk of wrecks, injury and theft. You do not want this risk, but for a fee, your auto insurance company does. You transfer the risk to them.

When you buy a one-year magazine subscription, you are transferring risk. The magazine company is at risk if the price of its magazines goes way up.

Of course, you are at risk if the price stays the same or falls. But for the upfront fee, you both consider the risks mutually beneficial.

The options markets are a standardized way for the financial markets to transfer risk.

You can trade options through virtually every U.S. brokerage firm with just as much ease as buying or selling a stock. Usually, you will need to fill out an options application and wait a few days to get approval.

But if you don’t like options, I have another way for you to hedge yourself that I will share in a moment. First …

A Quick Refresher on Options

What exactly is an option? Options give owners the right, but not the obligation, to buy or sell certain securities (or indexes) at a fixed price over a given amount of time.

Because the owner has the "right, but not the obligation," this means the option buyer chooses whether or not to buy or sell the underlying stock — it is their option to do so.

There are two basic types of options: calls and puts. Call options give the owner the right to buy the stock (or "call" it away from the owner), while put options give the owner the right to sell the stock (or "put" it back to the seller).

This is a contractual obligation, controlled through a clearing firm (called the Options Clearing Corp. or OCC). So, there is no need to worry about a defaulting party on the other side of the transaction.

Because they are contractual obligations, options trade in units called contracts. Just as a stock is traded in shares, one contract usually represents 100 shares of stock.

Options are standardized, meaning there are only certain prices at which you can agree to buy/sell stock as well as specific periods. The prices are set by the exchange at fixed intervals and are known as strikes, because that is the price where the contract is struck.

As for the periods, you will always find at least four different months for stock options. There will always be the current month, the following month, and at least two additional months.

Also, there may be longer-term options that can go out in time for as long as three years.

Options have a specified expiration date, usually the third Friday of the month, but many stocks and indexes also have options expiring the first, second and fourth Fridays of the month.

Depending on your brokerage platform, you will see these "weekly" options denoted as Week 1, Week 3, Week 4, etc. You may also see the number of days until expiration, to help you select the correct option.

(In my Global Resource Hunter, Gold and Energy Investor and Junior Resource Millionaire recommendations, I always include the expiration week or make note that it’s a "monthly" expiration, where applicable.)

That’s a lot of information, so I’ll use the traditional third Friday of each month to make my examples easy to follow.

How the Options Markets Work

 … (and Work in Your Favor!)

Let’s say it is October and you are bullish on XYZ stock trading at $50. You could purchase a January $50 call option that gives you the right, but not the obligation, to purchase XYZ for a price of $50 through expiration in January.

Now, of course, there is a fee for this, called the premium,and let’s say it is $5. This means that you are paying $5 per share, but remember, each contract controls 100 shares, so the total purchase price for one contract would be $500 (plus brokerage fees and commissions).

Once you buy the January call option, you have the right to buy the stock at $50 per share at any time through expiration. If XYZ is trading for $70 when the option expires, the call option must be worth $20 (the difference between the stock price and strike).

However, if XYZ is trading at $70 before expiration, then the option will be worth at least $20, as there will still be time remaining on the option and investors are willing to pay for time.

How much they pay is up to the market and determined solely by supply and demand for the option.

Of course, if the stock closes below $50, the option expires worthless, so the most you can lose is the amount paid, in this case, $500.

You may be thinking, "Hey, wait a minute, how do I know the market-makers won’t try to rip me off and only offer me $15 for the call when I decide to sell?"

If XYZ is trading at $70 and the market-makers are bidding $15 for the $50 call, then the arbitrageurs will step in and come to your rescue!

These are people who watch for price discrepancies in the market and are able to make riskless transactions for just about guaranteed profits. These transactions happen at lightning-fast speeds and do not last for long.

Arbitrageurs will buy the call for $15, sell short the stock, and receive $70 for a net credit of $55. They will then exercise the option (use it to buy stock) for $50 and keep the $5 profit — exactly the amount the market-maker, in this example, was trying to steal!

This process will continue until it disappears, at which point, the option will be trading for $20.

So, have no fear — the market-makers cannot steal the intrinsic value (the difference between the stock and strike) of your option!

What if you were bearish on XYZ? Well, you could instead buy a January $50 put. Now you have the right, but not the obligation, to sell your stock for $50 per share through expiration in January.

If XYZ is trading for $40 at option expiration, the put must be worth $10 (the difference between the strike and the stock price). If XYZ is trading at $40 before expiration, the put must be worth at least $10, as there will still be time remaining.

If a market-maker decided to only bid $8 for the put, arbitrageurs will buy the put for $8, buy the stock for $40 (far a net debit of $48), exercise the put and sell the stock for $50 for a guaranteed profit of $2.

Again, this process (which is measured in seconds) will continue until the put is priced fairly at $10.

Also, these days with high-speed trading, arbitrageurs are usually hunting to make as little as 50 cents even 10 cents. The likelihood of making more than a dollar on any one option arbitrage is low.

So far, we have only considered the owners or buyers of calls and puts. What about the person who sold them?

Well, the seller of any option has an obligation to perform.

If you sell a call, you must sell your stock if and when the owner of the call chooses to buy it. If you sell a put, you must buy the stock if and when the owner of the put chooses to sell it.

It is only the owner (the long position) who has the right; the seller (short position) has an obligation.

Gain a ‘Hedge’ Edge

Now that you have the basics of options, let’s look at ways to hedge and see if hedging sounds like a good idea to you!

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Assume hypothetically in late May eBay (EBAY) was trading for $55 a share. Later, in mid-July it jumps $15+ to above $70.

You decide you want to keep the stock but believe there’s a chance that on July 18 (hypothetically) when earnings are announced, the EBAY might dip.

So, if you decide to buy a Week 4 July $70 put trading for $2 (note that these are examples and not actual prices), here’s what can happen …

By placing this trade, you are betting on a profit of at least $13 per share through expiration on July 25 (the fourth Friday of the month). This is because you can always sell your shares for $70, but it cost you $2 for a net of $78.

Because you paid $55 for the stock, the put entitles you a $13-per-share gain.

Now consider the advantages of this trade. If the stock starts to fall, when you bought the $70 put, we now have removed the emotional side from our trading. Your potential gain is locked in!

Owning the put allows you to focus on fundamental values of the company, and not the short-term downtrend. You can hold the stock if you believe it is just consolidating and will move higher after the July expiration.

By buying a put option, there’s also no fear of a maintenance call (for those who trade on margin). Best of all, it’s easy to sleep at night knowing you never have to look back and think, "I should have sold that back when it was $70," because now you have the option to do so!

It’s not a bad deal if you think about it — the opportunity to lock in profits of at least $13. And by buying the $70 option, you have only limited your upside by the $2 cost of the put option (your insurance on the position).

Perhaps the earnings report turns out to be a bullish catalyst and the stock jumps to $80. In any case, you’ve only increased your cost in EBAY by $2.

When I recommend hedging like this, I call it "placing a put option under a stock position."

Why a Hedge is Never Truly a Waste

Now some people think the "downside" to this trade is, if the stock continues to run higher, you would have effectively "wasted" $2 on the put.

However, is your home insurance a waste just because it never caught fire? Of course not, and you shouldn’t feel that way about the placing a put under a stock position either.

In fact, because you still participate in all of the upside movement of the stock (less $2), the best thing to happen is for the stock to climb higher.

In this case, if it goes up another $10, your put may expire worthless. But all the while, you’re protected against a bad earnings call while still leaving yourself the vast majority of the upside.

Let’s look at our profit and loss profile (at option expiration) on the trade above with and without the put.

It is easy to see the value of the protection here. Look at the profit/loss for the two positions in the table above.

If the stock closes at $100, the long stock position will have a gain of $45 points ($100 minus the $55 cost), while the long stock/long put position will have a gain of $53 (this is due to the $2 spent on buying the put).

There will always be a $2 difference between the two positions for all stock prices at $70 or above.

So the investor who hedged the portfolio will only be off by $2 in terms of profit and loss to the upside, but look at the difference to the downside!

I’d Say That’s $2 Well-Spent!

For any stock price below $60, the hedged approach dominates.

For example, say the stock closes at $40. The investor who bought the shares at $55 is down $15.

The investor who hedged is also down $15 on the stock, but the $70 put must be worth at least $30 (the difference between the strike and the stock price).

This means a paper profit of $15; however, we must subtract out the $2 cost of the put, which gives us a total profit of $13.

This $13 profit will hold for all stock prices below the $70 strike of the put. This is exactly what happens in a fully hedged position. The loss on the stock is exactly offset by the gain in the option.

Bringing it back around to our EBAY example, there was no need to necessarily have hedged the position at $70. If you were willing to take a $5 "deductible," you could have elected to purchase a $65 put.

This would be cheaper than the $70 … for exactly the same reason your auto insurance is cheaper when you assume some of the risk through a deductible.

The options market will always give less value to a put with a lower strike, other factors being equal. So the choice is always yours. .. do you want more protection, or less protection at a lower cost?

Watching your chickens,

James DiGeorgia

P.S. I’ve already started working on my next article, which will be about "hedging with no out-of-pocket expense." There, I plan to show you another fascinating hedging technique that allows you to hedge all the downside risk, as above, but without paying for it!

Your thoughts on “How Stock Investors Can Hedge against Severe Losses”

  1. Enjoyed both articles. Good suggestions. Well Written. Thanks for the information
    Richard G Ehrhardt

  2. hello,

    I signed up to get the “Secret gold |Account” and still cannot get hold of it.

    Can you please help.

    Thank you.

    John Williams

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