Hedging using a long put to protect your assets can be cheap risk management strategy.
Hedging for Cheap
Hedging: using a long put as a hedge.
Assumed portfolio value: $50,000 in SPY, price $322 as of 7/31/2020
Goal: protection from potential stock market correction of 25% at end of year
Strategy: long put expiring Jan 2021, $320 strike, cost of $2100 (4% of portfolio value)
Scenarios:
- SPY loses 25%
- SPY gains 4%
- SPY gains 10%
If SPY loses 25% by Jan 2021:
SPY = $242
Put return = 275% = $5775
SPY existing position at -25% return = $37500
Total portfolio value $43275 (-14% return)
If SPY gains 4% by Jan 2021:
SPY = $334
SPY existing position at 4% return = $52000
Put return = -95% = $-2000
Total portfolio value = $50000 (0% return)
If SPY gains 10% by Jan 2021:
SPY = $354
SPY existing position at 10% return = $55000
Put return = -100% = $-2100
Total portfolio value = 52900 (2% gain)
scenario (-25%):
saves 11% of loss
scenario (+4%):
misses 4% of gain
scenario (+10%):
misses 8% of gain
Selling covered calls on your long position to reduce the cost basis of your hedge
Hedge costs you 4% and you can likely earn 4% with 3-4 months of calls.
Then your hedge at that point was free for you and you get the protection without the drawbacks.
If your shares get called during one of the 3-4 months you’re selling, then you can either buy back in right away or sell a Cash Secured Put to get back into your long position and earn premium for doing so.
