It is classic hindsight to claim that one would have taken profits from the hedge at just the right time, but in reality that rarely happens.
For most investors, loss aversion kicks in, and hedges with significant time to expiration are rarely taken off at the just the right time. Without that skill of timing the market, maintaining long put option positions is very costly, and that should not surprise us; after all, equity markets do tend to rise in value over the long term.
Over the long term, however, both have burdened investors with costs. Option markets typically are not in the business of losing money from selling investors insurance on portfolios any more than real insurance companies are in the business of losing money from insuring houses or lives.
There are ways to address the challenge of down markets with options strategies, but in our view, simply buying and holding put options, whether short- or long-dated, at-the-money or out-of-the-money, is not one of them. This material is provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability.
All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Neuberger Berman products and services may not be available in all jurisdictions or to all client types. This material may include estimates, outlooks, projections and other "forward-looking statements. Investing entails risks, including possible loss of principal. Investments in hedge funds and private equity are speculative and involve a higher degree of risk than more traditional investments.
This generally means purchasing put options at lower strike prices and thus, assuming more of the security's downside risk. Investors are often more concerned with hedging against moderate price declines than severe declines, as these types of price drops are both very unpredictable and relatively common.
For these investors, a bear put spread can be a cost-effective hedging strategy. In a bear put spread, the investor buys a put with a higher strike price and also sells one with a lower strike price with the same expiration date. This only provides limited protection because the maximum payout is the difference between the two strike prices.
However, this is often enough protection to handle either a mild or moderate downturn. Another way to get the most value out of a hedge is to purchase a long-term put option, or the put option with the longest expiration date. A six-month put option is not always twice the price of a three-month put option. When purchasing an option, the marginal cost of each additional month is lower than the last. In the above example, the most expensive option also provides an investor with the least expensive protection per day.
This also means that put options can be extended very cost-effectively. If an investor has a six-month put option on a security with a determined strike price, it can be sold and replaced with a month put option with the same strike price.
This strategy can be done repeatedly and is referred to as rolling a put option forward. By rolling a put option forward, while keeping the strike price below but close to the market price , an investor can maintain a hedge for many years. Adding extra months to a put option gets cheaper the more times you extend the expiration date. This hedging strategy also creates an opportunity to use what are called calendar spreads. Calendar spreads are created by purchasing a long-term put option and selling a short-term put option at the same strike price.
However, this practice does not decrease the investor's downside risk for the moment. If the stock price declines significantly in the coming months, the investor may face some difficult decisions.
They must decide if they want to exercise the long-term put option, losing its remaining time value , or if they want to buy back the shorter put option and risk tying up even more money in a losing position. In favorable circumstances, a calendar spread results in a cheap, long-term hedge that can then be rolled forward indefinitely.
However, without adequate research the investor may inadvertently introduce new risks into their investment portfolios with this hedging strategy. When making the decision to hedge an investment with a put option, it's important to follow a two-step approach. First, determine what level of risk is acceptable. Then, identify what transactions can cost-effectively mitigate this risk. As a rule, long-term put options with a low strike price provide the best hedging value.
This is because their cost per market day can be very low. Although they are initially expensive, they are useful for long-term investments. Long-term put options can be rolled forward to extend the expiration date, ensuring that an appropriate hedge is always in place. Ensure that your puts are reflective of your portfolio. Keep in mind that this is just option protection, so you have to be fully willing to lose the option's premium the price of the option. That being said, at the current frothy market levels we're trading at, going into this highly uncertain earnings season and implied volatility being relatively low: this is a smart move.
Don't hold these things till expiration but rather scale out of them as the price moves down, and you can even buy more as the ETF's price moves up only do this if you are willing to put on more risk.
If you don't feel comfortable with options, then I would suggest you stay away. Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days.
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If we want to find a stock that could multiply over the long term, what are the underlying trends we should look for The vertical spread, on the other hand, protects the investor up to the strike of the sold put option or the lower-priced strike. Since the protection is capped, it's less costly than a stand-alone put.
Put options provide downside protection for a long position. Even though the protection offered from the vertical spread is capped, it can be quite helpful if the stock is expected to have limited downside moves.
For example, a well-established company's stock price might not fluctuate too wildly, and a put spread could protect an investor within a range. It's important that investors become familiar with the various types of options before entering into a trade. Many brokers require investors to complete and pass an online training class before an investor can execute hedging strategies with options.
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