PRO: Preserves most of the upside potential
of the long stock and can give you nearly full
protection in a crash.
CON: Costs money and increases the
breakeven point of the long stock position.
VOL SCENARIO: Low volatility is preferred,
as the cost of the long put is likely lower.
If you’re willing to pay for downside protection, while leaving the upside potential
unlimited, the long put option may be your
style. To place a long put hedge, you simply
buy a put with the same strike as the stock
price (at-the-money, ATM) or below the
stock price (out-of-the-money, O TM). See
Say you own a stock at $175. A $170 put
might cost you $5. As long as the stock
remains above the strike price of $170 at expiration, then the long put’s going to expire
worthless, and you’re out the $5, or $500
per option. Anything below $170 before
the put expires and you’re fully protected,
dollar for dollar, even if the stock drops to
zero. All you’re out is the $5 you spent on
news doesn’t apply to your stock, there
could be guilt by association.
Global risk—Stocks can feel the heat when
they’re in a sector that’s sensitive to global
events. For example, tariffs, central bank
activities, and trade wars can affect companies in base metal and banking sectors. If
your stock’s sector could be affected by volatility, hedging that stock might be smart.
In each of these scenarios, if you don’t
want to sell the stock, it might make sense
to simply hedge it. Depending on the volatility of the market and the hedging strategy
you choose, you can reduce the risks of
holding on to the stock during a downturn,
while maintaining some or all of the upside
in case the stock should move higher.
VOL-BASED HEDGING S TRATEGIES
There isn’t necessarily a good, better, or
best hedge. Some leave room for greater
upside potential, but compromise more
downside protection, or vice versa. Among
other factors, it’s important to look at a
stock’s volatility and use parameters to
choose the hedge that matches your outlook for the stock’s risk.
Let’s look at three types of hedges you
could consider overlaying on an individual
stock position: long put, collar, and covered
call. Each has its pros and cons, and each
has its own use as a hedge.
An individual stock can often be more
volatile than an entire portfolio. A sector
that falls 10% or 20% in a correction can
mean twice that for individual stocks. And
because you can’t predict a bear market,
you ought to be prepared.
Let’s look at three common but frequently
overlooked risk scenarios that could dramatically affect individual stocks. Once
you understand these risks and when they
might occur, you can create a plan to hedge
THREE RISK SCENARIOS
Stocks can be at risk of a pullback for many
reasons. Here are three broad scenarios
where your individual stocks may carry
risk that might not affect your portfolio as
Stock risk—For a stock that’s outperforming
the overall market, there’s always the risk
of the stock coming back down to earth,
particularly if the stock market as a whole
is falling. For example, if you own any of the
five “FAANG” stocks, their high prices may
mean they could have further to fall. If a
downturn in one stock can spoil your year,
your stock risk may be worth hedging.
Sector risk—Your stock can
be affected by news that
moves the sector as a whole,
such as lower industry
demand for products of
stocks within the sector. If
your stock’s sector has been
outperforming the rest of
the market, or if your stock
is outpacing other stocks in the sector, it
could be affected significantly by negative
news that hits the sector. Even if the bad
FIGURE 1: Long put. Risk graph showing a long 170
put option. For illustrative purposes only.
You’ve gotta love a diversified portfolio of stocks that work together
with the goal of reducing risk and increasing returns. No one stock
is more important than another, although you may have your favorites, like those that have outpaced the rest of the market. But maybe a
sector seems ripe for a downturn, or perhaps your stock is in a sector
that got hit with bad news. And you’re not ready to sell just yet.