Hedging

The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn’t prevent a negative event from happening, but if it does happen and you’re properly hedged, the impact of the event is reduced.

If you take insurance out on something that you own: such as a car, house, or household contents, then you are basically protecting yourself against the risk of loss or damage to your possessions. You incur the cost of the insurance premium so that you will receive some form of compensation if your possessions are lost, stolen, or damaged, thus limiting your exposure to risk.

Hedging in investment terms is essentially very similar, although it’s somewhat more complicated that simply paying an insurance premium. The concept is in order to offset any potential losses you might experience on one investment, you would make another investment specifically to protect you.

For it to work, the two related investments must have negative correlations; that’s to say that when one investment falls in value the other should increase in value. For example, gold is widely considered a good investment to hedge against stocks and currencies. When the stock market as a whole isn’t performing well, or currencies are falling in value, investors often turn to gold, because it’s usually expected to increase in price under such circumstances.

Because of this, gold is commonly used as a way for investors to hedge against stock portfolios or currency holdings.

The name of this site is Main Street beats Wall Street with options. So let’s go over a few ways a trader might hedge with options.

Using options for hedging is, relatively speaking, fairly straightforward; although it can also be part of some complex trading strategies. Many investors that don’t usually trade options will use them to hedge against existing investment portfolios of other financial instruments such as stock. There’s a number of options trading strategies that can specifically be used for this purpose, such as Covered Calls and Protective Puts.

With a Covered Call you buy a stock which is a Long position and you hedge the stock position with the selling of a Call Option, which is a Short position. If the stock goes down in value, the Short option will gain in value. With the selling of an option, the insurance or hedging is limited to the value of the premium you received.

Implementing a Protective Put involves being long the underlying stock and buying a Put option on that stock. A Protective Put is typically used when an investor is still bullish on a stock but wishes to hedge against potential losses and uncertainty. If the stock goes down the Protective Put allows you to Put (sell) the stock to someone at the higher Strike Price of the Put. The Put seller is obligated to buy your stock and the agreed upon Strike Price.

 

Triple Play Hedge

Please read my page on Triple Play Hedge. The Triple Play hedge is a strategy I invented which gives me a nice amount of hedging while getting paid 3 premiums. It works the same as a Covered Call with a lot more insurance. as I wrote earlier, with a Covered Call you sell an option against shares you own. And your insurance is limited to the premium you received for the sale of the option. With a Triple Play hedge, I have a stock and sell a At-the-Money Call Option against those shares. In addition, I sell 2 more Naked Call Options with each Call Option a week out further on the Expiration Date and a little higher Strike Price. This gives my 3 Call Options which increase in value if the stock goes down because they are Short positions. If the stock goes up, because of the further out Expiration Date, I have time to Cover the Calls if needed, one at a time as the stock gets up to the next Strike Price. I have been very successful at many Triple Play Hedge trades. With this strategy I like to use a stock I’m not very bullish on. I like stocks I feel will move sideways for a little while.

With this strategy I like to get assigned on my first Call. I increase the chances by selling an At-the-Money Call. The next 2 Call are Out-of-the-Money, they have less chance the stock will get up to the price I of those Strike Prices.