How to use Options to protect your portfolio?

Publish Date: May 20, 2019

By: Sandhya Kannan, Head – Content

While watching financial news channels, you might have come across terms like ‘call', ‘put', ‘hedging', and ‘premium'. If you are planning to trade in options, these jargons can help you in making the most of your investments.

To get higher profits in options, you need to use the ‘call' and ‘put' option smartly. The ‘call' option indicates your right to buy the underlying asset at a pre-determined price, while the ‘put' option indicates your right to sell the stock at your pre-decided price. This pre-decided price is called the strike price. For both, ‘call' and ‘put', the sale and purchase of stocks can happen until the mentioned expiration date. The ‘call' option can help you in buying cheaper. Thus, you will gain a higher profit, as markets rise. However, stock markets are volatile. So, how can you save yourself from a sharp fall in your stocks? To cushion your stocks against the market fall, you can use the ‘put' option. It acts as your portfolio insurance during stock market crashes. Read more about options trading here.

Here are the various ways in which buying options can protect your portfolio:

Writing a covered ‘call' can help

As discussed earlier, by using the ‘call' option, you can buy the underlying asset at a pre-determined price. However, you are not obliged to buy the asset for the agreed price, or before the expiration date. Buying covered ‘call' is usually preferred to enhance earning, but they can also help you protect your portfolio during market plunges. You can apply this strategy when you are sure that the stocks you hold may not fetch you much profit. By selling (writing) the ‘call' option at a higher strike price, you receive premiums until the strike price is reached. To get a deeper understanding about how the call options work click here.

-  What is a covered ‘call'?

When you execute the covered ‘call' option, you lock the upside of the underlying investment and try to capture the limited upside with the help of the premium. In a covered ‘call' the seller of the ‘call' option holds a long position of stock and simultaneously writes (sells) the call option on the same asset. In such a ‘buy-write' strategy, the long position of the underlying asset provides a ‘cover' when the buyer of the option decides to exercise the ‘call' option. If the buyer does not exercise the option, and the option expires, the seller will receive a premium until the option expires.

Say you own 100 shares of XYZ company, at the market price of Rs.50 each. If you don't expect the stock prices to move up. You can write (sell) the call option at the strike price of Rs.55 for 100 shares. Here, you will receive a premium of Rs.2/share on selling the option. Therefore, for your entire lot, you will receive a premium of Rs.200. Click here to know about the most active call options.

-  How does it reduce losses?

Suppose, you bought 100 shares of XYZ company at Rs.50 each, thinking that it will rise to Rs.60. To create a covered ‘call' option, you can sell the ‘call' option at the strike rate of Rs.55/share. Here, you will receive Rs.6/share or Rs.600 as premium. Consider, the price falls to Rs.40/share. Due to the covered call strategy, you can save yourself from the outright loss of Rs.1000 on your portfolio. Therefore, your loss would be reduced to Rs.4/share, i.e. Rs.400 (Rs.1000 – Rs.600 = Rs.400). The Rs.600 premium received offers a cushion against the stock price decline.

Put Option: Your portfolio insurance

Insurance can help you cover financial losses against uncertainties. Similarly, the ‘put' option can act as your portfolio insurance against market volatility. Every insurance has its price. In insurance, it is the premium. However, in options, it is the price you pay to buy the put option. By using the ‘put' option, you can sell your stocks at a pre-agreed strike price. It can help you in cutting or avoiding your losses. To know more about how the put options work click here.

-  Here's how using the ‘put' option can help:

Let us say you buy stocks of an agro-products company. Now, due to the recent rise in inflation, you are worried that your shares will plummet. Inflation is a short-term uncertainty, but it can be harmful to your portfolio. During such uncertainties, you can use the ‘put' option to hedge the risk. Say, you bought 100 stocks at Rs.30,000 (Rs.300 multiplied by 100 shares). Consider, you have purchased the ‘put' option for Rs.25 per share, or Rs.2500 for the entire lot, with an expiration date of 3 months. Therefore, you have paid Rs.32,500 (Rs.325 per share for a lot of 100 shares). Your strike rate is Rs.35,000 (Rs.350/share). Consequently, you have paid 8.33% premium to buy the right to sell your lot of 100 stocks at Rs.35,000, any time before three months. Click here to know more about options trading.

- Here's how you can cut your losses, using the ‘put' option:

Now suppose, the stock price has fallen to Rs.250/share, a month after you bought the option. However, you have the right to sell the lot at Rs.350/share. Therefore, you will still get a profit of Rs.25/share, in spite of the ongoing market plunges.

Look for Long-dated ‘put' options

It is a bearish strategy (used when you expect the market to fall). Consider the indices during FY2018-19. Equity market witnessed a roller-coaster ride during this period. Also, during the ongoing election season, markets are going through the volatile period due to elections. You can consider yourself lucky if you had purchased a long-dated ‘put' option, last year. Therefore, to protect your portfolio from these risks, you can consider buying long-dated ‘put' options. ‘Put' option with a more extended expiration date can give you higher flexibility on when to exercise your option. Click here to know mere about how put options work.

- What are Long-dated options?

In a long-dated option, you can quote for a more extended expiration date. Investors usually buy long-dated ‘put' options with an expiration date of 12 months. However, they can stretch for as long as five years. If you buy a long-dated ‘put' option with a one year expiration period, you can either exercise it or let it expire. You can even roll it over to the next year. For this, you need to hold a specific minimum portfolio size. Usually, this is Rs.10 Lakh. The price of this option is calculated considering the intrinsic as well as the time value of the asset. Check this link to read more about the intrinsic and time value of options. A 3 year, long-dated ‘put' option is generally priced around 1.5-2% per year of your total portfolio cost. Click here to about options strike price.

- How can buying long-dated options help?

These options ensure your portfolio for a longer time than your typical ‘put'. The price for these options is not much higher when compared with the short ‘put' options. You can even settle for a considerably lower premium if you settle for ‘out-of-the-money' put option (here, the strike price is lower than the spot price of the stock).

-  Here's an example:

Cosider that you bought 100 stocks of XYZ company at Rs.1000 each, in 15th May 2018. You paid Rs.15 per share for an expiration date of May 2019. Your strike price is Rs.1100 per share. Therefore, you paid

(Rs.1000 x 100) + (Rs.15 x 100) = Rs.1,00,000 + Rs.15,00 = Rs. 1,01,500

To buy the right to sell the stocks at

Rs.1100 x 100 = Rs.1,10,000

Untill 14th May 2019.

Now suppose, due to the ongoing election season, the stock prices fall to Rs.900 per share. It is struck between the range of Rs.900-Rs.910 per share, for the period after April 30, 2019.

Therefore, by exercising your long-dated ‘put' option, you will still be able to sell your portfolio for Rs.1100 per share, before 15 May 2019.

Therefore, you can protect your portfolio from the market plunges, by merely purchasing long-dated ‘put' options.

Hedge your risk

Hedging eliminates or reduces risk only by holding one particular investment position and simultaneously taking another. The options market is versatile, therefore making it useful for hedging. While trading in options, you can hedge the current position by taking-up an opposite position. Insurance is a perfect example of how hedging works. Under ideal circumstances, you should not face any health/life/property loss risk. However, to cover this risk, you pay a premium amount, that would cover you (financially) in-case such uncertainties occurs. In simple words, the compensation received limits your exposure to risk. Click here to read more about hedging.

- What does hedging in options mean?

In hedging, to offset any potential loss that may occur to your investment, you make another investment specifically to cover you. The second investment is usually for the opposite position. Therefore, if one investment falls, the increase in the other will cover the loss. Now, you might be thinking, how is this applicable to options trading?

- Here's how hedging can protect your portfolio?

Hedging in options is quite simple. It just involves buying or writing (selling) options, to protect your position. Suppose, you hold 100 shares of XYZ Company, at Rs.300 per share. Since the share price is falling, you have purchased a lower put option. Now, as the amount of the equity goes down, the cost of the option goes up. Your strike rate is Rs.290 per share, at the premium of Rs.3 per share. Now, it is assured that, under any circumstances, your loss on the position will not fall below (Rs.300 – Rs.290 + 3) Rs.7 per share.

Therefore, your maximum loss is clearly defined, due to hedging. The ‘put' option will compensate for the notional loss if the price of the asset falls below Rs.290. However, if the stock price goes above Rs.303, you will cover the premium you paid for buying the ‘put' option, and the profit chart will move North. In such a case, you will gain more by not exercising your option. Click here to read more about hedging against a small cap crash.

From the above discussion, we can say that options are "rights without obligations". They can protect your portfolio from volatile market downturns. By using ‘call' and ‘put' options well, you can gain even during market plunges. They can offer the investors an option of cutting losses or avoiding them during a sharp fall in stocks. By buying options, you buy time to see how your stocks play out in the market. It offers you flexibility along with helping you manage your investment risk.

Also read:  

• Understanding how put options work
• What can you learn by tracking bond yield movements?
• 7 things that are moving markets
• What can you learn by analysing a company’s debt profile?
• Finding Value in Midcap Stocks