Do you want to reduce your exposure to unexpected stock market price swings? While stocks will always carry some level of risk, there are ways to hedge against price movement. Now, even though hedging strategies can be used for different purposes, this article will help you examine the various options that you can use to protect your portfolio.
Put option
A put option is a “right” (and not obligation) to sell a stock at a specified price -- the buyer will, in turn, have to pay a premium to purchase a put option. For example, say, an investor named Lisa buys a stock at $14 per share. If the value of the stock goes up, Lisa will earn a profit. However, if the value of the stock plummets, she can exercise her right to terminate her position and sell the stock at $14. In this case, Lisa would lose only the premium that she paid for the put option.
Downside risk
Option pricing determines the price of an option as a function of its underlying security and is measured by risk. Risk is derived from the financial variables that may affect the price of the stock, such as the earnings per share, dividends, and volatility, just to name some.
An investor can determine how much they stand to lose as the result of a drop and decide if there is a need for a strategy like a put or a call option. Investors who try this strategy must first determine the right timing, so they do not lose all their money prematurely.
Keep an eye on strike price and expiration date
Expiration dates also play a big role in determining an option's final price. So, having all the information to make the best decision means considering both the expiration date and strike price side-by-side. It is important that the strike price is within the range of what you can afford because if you exercise your option early, there could be a loss. Consider setting your strike price at a point where you are not locked into staying with the stock if it should begin to slide so that you don't have to suffer any losses before being able to sell it.
Bear put spread
The bear put spread is a variation on the more general strategy of selling a put option. In this particular strategy, the investor buys one put option with a lower strike price and sells one with a higher strike price; the net result is a limited profit potential regardless of how far the stock falls.
