Using Options to Hedge and Enhance Stock Returns

Options are financial instruments which give the holder the right, but not the obligation, to buy (call option) or sell (put option) a stock, at a set price price within a specified period (typically  under three months).

In addition to being high-leveraged trading instruments, options can also be used for managing the risk in an investor’s stock portfolio as well as enhancing the overall portfolio returns. Historical stock data analysis suggests that the portfolio’s using options for risk management have higher risk-adjusted returns than stock-only portfolios.

Purchasing put options is the simplest and most common method for hedging against stock price declines. By adding put options on individual stocks or a broader stock index to a portfolio , investors can set a “floor” for their portfolio’s value. If the market or the individual stock declines, gains from the put options can offset losses.

Example: Suppose an investor has a $500,000 stock portfolio, including 1000 Tesla (TSLA) shares valued at $220,000 (ie $220 per share in early 2024). In early 2024, expecting market volatility, the investor purchases 1000 6-month TSLA put options at strike price of $180. This trade will effectively cap the loss on TSLA at $40,000 (plus the cost of the options).

While put options can protect against the against downside risk, covered call strategies can earn additional income on the existing stocks in a portfolio. In a covered call strategy, the investor sells call options on stocks in the portfolio, generating addiotional income from the option premiums. However, this strategy may limit potential gains if the stock price exceeds the strike price.

Example: Suppose a portfolio includes 1000 shares of Alphabet (GOOG), trading at $150 per share. The investor sells 1000 6-month call options with a strike price of $170 for a premium of $8. If Alphabet’s stock price stays below $170 for the 6-month period of the option term, the premium of $8000 will be reconized as additional portfolio income. If the stock price rises above $170, the stock could be ‘called’ by the option holder and the investor will thus forfeit the returns of the stock above $170.

Short Option Terms

Options are usually only liquid a maximum of three or six month from the present date, Thus the investor will need to track expiry dates of all options to ensure they are either exercised or allowed to expire and then replaced. This adds considerable administrative overhead to managing a stock portfolio.

 

Cost of Options

Buying options requires paying a premium, which can reduce portfolio returns. The cost of options varies based on market conditions so the price of insuring the portfolio can suddenly spike during periods of higher volatility.

 

Margin Requirements

Selling options requires posting margin to cover potential losses. This can consume additional capital and will require the investor set aside funds which could be used for other purposes. Margin requirements are also uncertain vary over the term of the option and so the investor can be faced with additional demands for capital if the option position is losing money.

 

Basis Risk

Options might not perfectly match the underlying asset’s movements due to differences in settlement prices. For example, a put option on the S&P 500 index may settle against the average price of the index on expiration day, while your portfolio value is based on closing prices.

 

Complexity

Options trading can be complex, especially for beginners. Investors need to understand the mechanics of options, various strategies, and potential outcomes. Managing a portfolio with multiple options positions, such as straddles or strangles on stocks like Amazon (AMZN), requires a thorough understanding of these strategies and their implications.

Incorporating options into an investment strategy can an investor effectively hedge against potential risks and better manage a stock portfolio. However, it’s crucial to consider the costs, margin requirements, basis risk, and complexity involved to make informed decisions.