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Inflation. Ukraine. Commodity Prices. Energy Prices. COVID. Government Debt. Interest Rates. Kirk Cousins. Did I miss anything? The reasons to be fearful about the market and economy (and the Vikings) are many, and your concerns are understandable. While most financial goals can be met by sticking to a long-term risk-return profile, there are times when hedging is appropriate. Using listed options can hedge against a downturn but still offer some upside potential.

Buying Insurance (Protective/Married Puts)

One of the simplest strategies is to buy insurance for your portfolio. Buying a Put is like buying home homeowner’s insurance. You pay a premium to protect your home for a certain length of time. The cost to buy homeowner’s insurance is usually between 0.50% and 0.75% of your home’s value, minus the deductible. If you don’t use the insurance to file a claim, it is an expense, but it provides you with peace of mind. And won’t destroy you financially if you had to replace a $500,000 home. 

Buying Puts is much the same as buying homeowner’s insurance. Listed options are traded on most stocks and ETFs (Exchange Traded Funds). If you are looking for an ETF to get exposure to the “market,” ticker SPY is a good choice. It mirrors the performance of the S&P 500 index. To buy one share of SPY as of the writing of this article is $425. You can also buy a Put on SPY that expires in one year, March 2023, with a Strike Price of $380 for $24 a share. What does that do for us? Well, for around a 5.5% expense of the position’s value, we can protect our position from a 9.5% or more decline for one year. One way to look at this is that our insurance cost is around 5.5%, and our deductible is 10.5%, for a total of $69 per share. If you combine the insurance cost (the Put @ 5.5%) and the 10.5% decline until the Put’s Strike Price, you have protection after a 16%+ decline. 

There is one way that buying that Put option can be better than homeowner’s insurance, and that is that you can sell the Put before the Expiration Date. SPY does not have to go down 10% for your Put to increase in value; it just has to go down and go down before expiration, most likely well before expiration. If you were to buy the March 2023 $380 Put in March of 2022 for $24, and in April 2022, the market dropped 5%, with SPY going to around $400, the price of that Put could easily rise to $30+ or higher, even though the market price of SPY did not drop below the Put’s Strike Price of $380. You could close out some or all of your position for a profit if you wanted. You would no longer have the insurance, but you do have the flexibility to sell your insurance if you wish.

The biggest advantage of this simple strategy is you still get full upside participation, minus the cost of the Put. Another option is to trade upside potential to pay for some or all of the downside protection. 

Zero-Cost Collar (Or at least a low-cost)

This strategy is more complex. It involves selling a Call to offset the cost of buying a Put. The result is a Zero-Cost Collar or a low-cost hedge. Upside is traded for paying for some, or all, of the downside protection. And would look something like this: 

As you can see, we paid for the Put mentioned above by selling a March 2023 Call with a strike of $445. Buying a Call gives you the right to buy a stock or ETF at a certain price for a certain length of time. Selling a Call means you are selling the right for someone to buy your security at a certain price for a certain period of time. And as you might guess from our Put discussion, buying a Put gives you the right to sell (put) your security to another for a certain price for a certain length of time.

Many factors go into listed option pricing (Puts and Calls), and unfortunately, when you match up the Call and Put premiums, they don’t always have identical upsides and downsides, but sometimes they do. Even with their complexity and flaws, if used correctly, Protective Puts and Zero-Collar Hedges could help you reach your financial goals and give you peace of mind.

Investing with options is complicated. Please make sure you know how they trade and the risks involved before attempting to use them. If needed, please consult your financial professional before acting.