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It has been a scary ride down over the last 10 days but we cannot let fear overcome us. Yes the S&P 500 has corrected 6.6% from its closing high, but did we forget it rallied 70% from its closing low?

I write today about using stock options to hedge your portfolio. Using options is considered to be expensive for some, but if you're like many Americans and you're stock portfolio is worth more than your house, ask yourself why you have home insurance and not portfolio insurance. I will outline a few ideas I have been using which I find work best and are the least expensive to hedge my portfolio, I am not telling you to go out and use these methods, but I have found them to hedge my portfolio greatly to the downside. If you are new to stock options and are interested in learning more about the strategies outlined in this post, risks, pricing, calculations, other strategies, and options in general, click here.

  1. Selling Covered Calls - This is one of my favorite methods of protecting and is by far the most basic, safest, and cheapest method I'll outline today. If I own shares on an optionable stock, I can write one call contract for every 100 shares I own for a premium. This gives me the choice to sell the shares at a price I am willing to sell the stock at, and puts money in my portfolio at the same time. So I'll give an example on Apple (NASDAQ:AAPL): With Apple trading just over 192 a share, I could be regretting not selling it at 200 a share. If that was me I would look to write out a February 200 strike call option against each 100 shares of Apple I owned. Using current market data, I could fetch $335 per option contract. If I wrote these shares out for 200 I would protect my position in Apple by 1.7% but I would also be obligated to sell Apple if the stock rose and closed above 200 per share on February 19, 2010 (February options expiration). If one anticipated a further decline in Apple shares there is always the option of writing a lower call contract closer to the current share price for a greater premium.
  2. Selling Vertical Call Spreads - This is a bit more advanced but is another method I really enjoy using to hedge my portfolio. Instead of spending a lot of money on put options and having time as my enemy, I like selling call options and having time as my friend. After a large move higher is usually when I implement this strategy, but it can be done at any time. Using the S&P 500 SPDR (NYSEARCA:SPY) and the Proshares QQQ (QQQQ) I write near and out-of-money vertical call spreads. Allow me to show you with the following example using the SPY ETF: If I believe the market could decline a bit further I would look at selling near-the-money call options on the SPY and purchasing a higher strike call option against each to limit my risk. For example I could sell the February 108 call options and purchase the February 113 call options against them and receive a credit of $160 per spread. This would put $160 (minus commissions) into my account for every spread, and would be profitable as long as the S&P 500 didn't rise by more than 2.1% over the next 20 days. If the S&P rises by more than 2.1% this strategy would not be profitable, however assuming my portfolio will move higher with the S&P 500 this should not be to my disappointment. The maximum loss from each spread is $340 and that is if the S&P rises by 5.2% or more and closes at those levels on February options expiration. Everyone has different holdings, therefore everyone needs to hedge differently. Figuring out how much one should hedge requires extensive research, because nobody wants to be "over-hedged", and lose money if the market were to snap back and move higher.
  3. Buying Longer Dated Put Options - This is my least favorite method of hedging, but is useful as it doesn't limit my gains like the previous example, however it also becomes more expensive in a rising volatility market and makes time my enemy. One of the most important things to remember when purchasing Put Options is to purchase Puts which have plenty of time left until they expire, this may seem more expensive but it is actually cheaper to buy a longer dated put than purchasing put options monthly. For example, I can purchase protection for over a third of one year looking ahead to the June options expiration. Using the S&P 500 SPDR (SPY) and current market data I can purchase the June 19, 2010 105 Put Options for $545 (plus commissions) per option contract. This would require an additional correction of 5.2% or greater just to break even after taking into account the premium paid, however profits can always be collected when one is convinced that the market is ready to move higher. This is where options with greater time until expiration come in handy, because if and when they are sold with greater than 60 days until expiration they'll still contain decent time premiums and won't decay as fast as options with shorter time until expiration.

    Let's say I was to purchase these put options and in 30 days I was convinced the market is ready to move higher so I'll sell some of my contracts, according to current market data and holding all values constant, this option would decay by $0.48 (48 cents) or 8.8% (compared to the February 105 put options which have $1.42 in time premium and will decay completely over the next 20 days), meaning I could still get $497 per option contract in time premium back at the time of sale. Of course this does not take into account any money that was gained or lost if the market moved lower or higher. If the market moved lower, according to current market data this would be profitable at the end of 30 days (taking into account time premium decay) if the S&P 500 moved lower by at least 1.2%. Remember price and time are not the only two metrics that could cause this option price to increase or decrease, so that should always be considered when purchasing options as well. Again, it is very important to conduct extensive research to determine how much would be an optimal hedging amount before doing so.

To get a better understanding of stock options and different option strategies please check out my Simplified Stock Option Trading E-Books. These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

The reason option volumes have surged in the last five years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.

Disclosure: Long February AAPL 130 Put Options, Short February AAPL 190 Put Options, February 185 Put Options

Source: Using Options to Play Market Correction