Options can be used to generate income, like in last week’s Alibaba (BABA) iron condor example. But they can also be used to protect a stock or ETF, like SPY stock, from a large drop in price.
Options are hedging instruments and are frequently used for portfolio protection.
Put options and bearish trades such as bear put spreads will do well when stocks drop.
Assume we own a portfolio of stocks that we want to hold for the long-term but are concerned about the short-term outlook.
Instead of liquidating our portfolio, we could buy put options or put spreads on the Spdr S&P 500 ETF (SPY) to help cushion the effects of any downturn.
SPY Stock: Bear Put Spread
With SPY stock trading around 452, an October 15 expiration bear put spread could be set up through buying the 420 strike put and selling the 410 strike put.
That spread was trading Wednesday for around $0.65 or $65 per contract, which is also the maximum potential loss.
To calculate the maximum profit, take the width of the spread (10), subtract the premium paid ($0.65), and multiply by 100. This gives us 10 — $0.65 x 100 = $935.
The break-even price for the put spread would be 419.35. This is calculated by taking the strike price of the long put (420) and subtracting the premium paid (0.65).
Buying protection like this can be expensive, but it can also help us sleep a little better at night if we are concerned about a large drop in stocks over the next two months.
Low Risk Trade
Some traders will spend around 1-2% of their portfolio value on put protection.
Put options can help protect against large price declines and are an important risk management tool for investors.
Please remember that options are risky, and investors can lose 100% of their investment. This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ.
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