Introduction to Options #7: Using Puts as a Hedge

Protecting an underlying asset


Puts are often taken when you already own the underlying asset. This strategy is referred to as hedging, where a position over an asset in one market protects against risk in another market. Most commonly, this might be used with shares as everyone knows they don’t always continue rising, they fall too.


Most investors would sell their shares, or hold out, hoping for a reversal. But if you sell the shares, not only are you subject to tax implications, you miss out on money if the stock rebounds. If you hold, you’re exposed to more risk. Puts ensure the underlying asset retains exposure to a potential rebound, but you limit downside risk by securing a sell price before expiry regardless of what happens. The most you can lose is the option premium. If prices fall, the premium and profits grow, offsetting losses in the shares.



The net result for profit and loss incorporates both the change in value of the underlying asset (shares), as well as the change in premium. Therefore, at expiry, first calculate the difference between the share price and what you paid for it. Then, add/subtract the option profit/loss, which is measured as its intrinsic value at expiry less the option premium paid.

As shown above, your potential net result is limited to the downside if the asset price falls, but unlimited to the upside if the asset price rises. Breakeven is the asset price you initially paid, plus the option premium you paid. Unlike other options, puts work best as a hedge when they expire worthless.


Closing out a put option


In this article, we discussed the exit strategies available when you want to close a put. Also, at expiry, if the asset price is above the exercise price, the put expires worthless. But when used as a hedge, this is a good outcome because the underlying asset has increased in value and offset this. On the other hand, if the asset is priced lower than the exercise price, you can do one of the following right until expiry:

  • Exercise the put

  • Sell the put or sell the asset or both

  • Roll over the put into another option for ongoing hedging via a longer expiry

When holding the underlying asset, it creates an added complexity because you need to decide what to do with it. If you are selling the option, you may sell the asset as well if you have a bearish outlook, or retain it if you think it will stabilise thereafter. Under the latter, you are no longer hedging. When you exercise the put, you deliver the underlying asset by selling it at the exercise price.


To retain the underlying asset but rely on further protection against falling prices, you roll over the put. As discussed previously, there is usually a cost difference when extending the option to a later date. For some traders, this cost may be worth the protection. However, you should only do this as a short term strategy, since the costs add up. If you hold a long-term bearish outlook, you may want to sell the asset.


Other factors when choosing puts


The level of hedging is an important attribute you should take into consideration when choosing between puts. Those puts which offer more protection, including a longer expiry, are those that are priced the dearest. This is why long-term puts are an unwise hedging strategy as opposed to selling the asset if very bearish. Consider the exercise price as a guide to protection, since a higher level gives you security to receive a higher sell price.

Should the asset price increase and protection is not utilised, you lose a higher premium. You also require the price to increase more than other circumstances to reach a higher breakeven point.


A put that is in the money may describe the above scenario as far as the greatest protection, highest premium, and highest breakeven point. Conversely, out of the money puts are cheapest but offer the least protection since they exercise below what you can currently sell for. Opting for an at the money put is a good medium, locking in the current price as a sell price, with a modest cost and breakeven.


Summary


  • Puts may be used as a hedging tool to protect an underlying asset you hold, affording you time while retaining exposure to a potential rebound, but limiting downside risk

  • When used as a hedge, the breakeven point is the asset price paid, plus option premium paid

  • When holding the underlying asset, you should form an opinion on its outlook when deciding to sell, exercise or roll over a put, and if you also plan to retain or sell the asset

  • You should look at the exercise price and expiry period to gauge the protection a put offers

  • Puts with the highest protection will command a higher premium and breakeven value, so sometimes it is beneficial to consider an at the money put for a good balance

  • It is often more sensible to sell the underlying asset than use puts as a long-term hedge

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