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How To Hedge Your Portfolio With Options Investing Strategies

By Jason Markum

Most people think that investing in the stock market is incredibly risky. After all, they think, if you make just one or two bad moves then suddenly you can see a lifetime of very careful savings evaporate in the blink of an eye.

Fortunately there are steps you can take to make sure this sort of thing doesn’t happen and that’s what I want talk about in this article today. I’m going to talk about how you can use options to hedge against the possibility of losing most of your money and stock market.

One popular way to protect yourself is to use options on market indexes to hedge against your portfolio’s market risk. As I’m sure you know, stocks have two main types of risks involved with owning them; their own company risk and the market risk.

By company risk, I mean things that affect the specific company such as quarterly earnings, lawsuits against the company, upcoming patents, research and development, etc.

By market risk I mean things that affect the overall market as a whole that will always affect individual stocks no matter what industry they are in to some degree or another. For instance, when there is a recession in the broader economy, it will hurt your specific stocks, yet that recession may not affect the specific company itself.

This particular strategy is good to use when you’re not quite sure what the future market has in store. If you don’t know what the market has in store, then chances are that you don’t know what the market risk to your own portfolio will be. In this circumstance you would buy a put option on the most standard market index that relates to your portfolio. Many times this will be the S&P 500 index or something similar.

If the market does decline and therefore drags your portfolio down with it, you will make a profit on the put that hopefully will offset any losses. If, on the other hand, the stock market increases, then that very increase should more than offset the minimal price you paid for the put option. I call this a win-win situation!

Of course, if you think that the market is going to decrease then your other option is to simply sell all your stocks right now and wait for the market to drop and then by back in. Of course this may be unrealistic depending on the size of your portfolio because the transaction costs for selling all that stock, and then buying it all back, may be prohibitively expensive even if you use a cheap online stockbroker.

Another risk to this strategy is market correlation. Most stocks are correlated to the market, which I alluded to earlier and which means that if the broad market drops your stocks will drop to. But there are instances where certain stocks aren’t tightly correlated to the market and if your portfolio is made up of stocks such as these, then hedging using a put on the S&P 500 may not be the best strategy for you to engage in.

I hope this short article will help enlighten you a little bit towards the benefits of investing with stock options and hopefully in taking away some of the fear that many investors feel when you so much as mention stock options. As with all investing opportunities, be sure to do your own homework before engaging in any strategies that may affect your portfolio returns.

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