January 28th, 2009Married Puts, Collars, And Hybrid Hedging
The market is heading up this morning, but I’m still not to eager to risk it all on the upside. Portfolio hedging is still crucial in these markets. There are many ways to hedge a portfolio, such as the collar. The collar trade is a three way combination of purchasing shares out right, selling a covered call against the position, and also buying a protective put against that same position.
A collar limits the risk to the downside through the use of the protective put. But it also caps the upside premium due to the covered call. For those that want to protect to the downside, but leave the upside potential untapped, then a married PUT is the way to go. A married PUT is the combination of buying shares in a security, and also buying a protective PUT to protect the position.
Hedging positions with either covered calls, collars, or married puts requires decisions on several factors, including:
- The strike prices of the covered calls and/or married puts
- The expiration months of the covered calls and/or married puts
There are many guidelines to help answer those questions, but experience, and your own risk tolerance are the best guides. Protective puts can be very expensive. For this reason, those with higher risk tolerance prefer to either go without them, or use them at lower strikes and close in expirations months.
Another portfolio hedging method that I often use is more of a hybrid model, with the expectation to adjust the hedging along the way. I may start off with long shares held completely naked without any hedging. If I’m nervous prior to earnings, then I’ll add a short term protective put (near term) just to get through earnings. Protective puts can easily be removed after earnings. If there is an artificial price spike then a covered call can be put on at or below the perceived price resistance level.
For a more in depth view of stock options and adjustments, I highly recommend the following book: