Here Are 3 Key Hedging Strategies If You’re Worried About a Pullback in the Stock Market

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Know Your Options Educational Series

Stocks have been sliding since Labor Day. This post will consider some potential hedging techniques if you’re worried about a deeper pullback.

The strategies use options, which give investors the right to buy and sell shares at given prices. Because they’re derivatives, options can generate much larger moves than the underlying securities. Calls fix the price where stocks can be bought, while puts lock in a selling price. We’ll consider:

  • Covered Calls
  • Vertical Put Spreads
  • High-Vega Puts

This post will also make use of options Greeks to explain the dynamics of how their prices change. This instructional series has more details, including a handy memory trick.

Covered Calls

Covered calls are one of the most straightforward and basic options strategies. While they’re typically bullish, traders can make them neutral/bearish by selecting contracts deep in the money.

Say you own 100 shares of Facebook (FB), which hit a new all-time high on September 1 and closed at $376.61 yesterday. If you’re worried that a decline in the S&P 500 will drag down their value, you could potentially sell 1 October 350 call for $29.90.

This trade would effectively lock in an exit price of $379.90 on FB. (That’s the 350 strike + 29.90 premium.) That is the amount you would receive if the stock closes at or above $350 on expiration and the calls were exercised.

This is more than FB’s current value because the October 350 calls have $3.54 of extrinsic value. Also known as time value, this value decays to zero as expiration approaches.

As a result, you have downside protection. FB could drop 7 percent to $350 and you could preserve almost 1 percent from current prices. The $3.54 of extra time value also provides extra cushion against a deeper drop below $350.

It’s noteworthy that traders can collect more premium by selecting higher strike prices. For example, the October 355 calls have $4.32 or extrinsic value and the October 360s have $5.24. These can generate more time premium amid a small drop, but also provide less protection against a deeper selloff. There’s never a free lunch.

Option Station Pro showing Facebook (FB) contracts cited in this article.

Vertical Spreads

One benefit of covered calls is that they pay a credit right away, rather than making you pay a debit. The next strategy costs money up front, but can also generate much higher returns: the bearish put spread.

Using the same 100 shares of FB as an example, a trader could potentially:

  • Buy 1 October 370 put for $7.90.
  • Sell 1 October 350 put for $3.30.
  • The cost would be $4.60 per share, or $460 in total.

Owning the 370 put gives you a right to sell FB for that price. Selling the 350s generates credit and obliges you to buy shares if that level is reached. Combining the two in a spread lets you control a move from $370 down to $350. You could collect $20 in the process. Based on the initial cost of $4.60, it would be a profit of 335 percent.

Unlike the covered call, the put spread would leave you holding shares.

High Vega Puts

“High Vega” puts may sound complex. But, they’re the cleanest strategy outlined in this article because they only involve a single contract.

Say you’re worried about a crash in the broader S&P 500. This typically drives up Cboe’s volatility index, or VIX.

You could switch underliers from FB to the SPDR S&P 500 ETF (SPY) and buy puts far out of the money and far out in time. Delta, which follows the direction of price, will be close to zero. Vega, which profits from implied volatility, will be relatively high. This could let you profit from the VIX spiking while also prevent you from losing too much money if the S&P 500 keeps rallying.

For example, the SPY December 2022 220 puts cost $3.21. With a Vega of 0.38, they could gain more than $7 if the VIX jumps to 40. (It last hit 40 in November.)

Alternately, say the S&P 500 jumps 100 points to a new all-time high. Because SPY moves $1 for every 10 S&P 500 points, the underlying shares would climb by $10. The December 2022 220 puts have -0.034 of delta, meaning they could lose less than $0.40 from such a move.

Option Station Pro showing SPDR S&P 500 (SPY) puts cited in this article.

The nature of these puts mostly separates volatility from movement. Their long time until expiration also reduces premium lost to time decay in the near term. These characteristics may spare investors the difficulty of needing to time the market — unlike shorter-term puts that are closer to the money and more sensitive to directional moves.

In conclusion, stocks have enjoyed steady gains since February. But now there could be potential risks with economic data missing estimates and the Federal Reserve preparing to taper asset purchases. If you’re concerned about a pullback, some of these strategies may interest you.

Disclosure: This post is intended for educational purposes only. None of the examples should be considered trading recommendations.

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