Options provide investors with the ability to actively hedge their portfolios against potential market crashes. This article discusses the importance of actively hedging in your options portfolio.
Reasons to hedge
One of the most important reasons why it is important to hedge aggressively with your options portfolio is that it is too late to hedge once a market crash has begun.
When the market crashes, stock prices crash and investors suffer huge losses. The time to hedge a portfolio is before a crash, not after. Proactive hedging involves taking steps to protect your portfolio before a market downturn occurs.
Active hedging involves buying options to benefit from market downturns. These options are typically put-he options that give the holder the right to sell the underlying asset at a given price.
When the market crashes, these put options rise in value, offsetting losses incurred on the underlying asset. Another reason why it is important to be actively hedging in your options portfolio is that it helps reduce the overall portfolio risk.
By purchasing a put option, an investor is essentially buying insurance against a potential market downturn. The cost of these options can be quite high, but they can provide a significant return on investment in the event of a market crash. In essence, active hedging is a form of risk management that helps protect investors from significant losses.
In addition, active hedging also helps investors to take advantage of market opportunities. When markets are down, there are often opportunities to buy stocks at bargain prices. Hedging a portfolio allows an investor to protect against losses while still having the funds to take advantage of these opportunities.
There is a well-known technique used to actively hedge while looking for profit. This technique is called the “color” strategy.
In this strategy, you buy put options to protect against downside risk and sell call options to make money. Proceeds from selling call options can be used to fund the purchase of put options, effectively creating “color” in the portfolio.
Collar is a trading strategy commonly used to limit potential losses on the underlying asset while limiting potential profits. It is created by combining a long position in an asset with a protective put option and a short call option.
Although collars are an effective way to protect an investor’s position in the market, this trading structure has some weaknesses. Here are some examples:
Limited Profit Potential: One of the main weaknesses of collars is that they limit the potential profit an investor can make. By using protective put options and short call options, investors are essentially giving up some of their potential gains in exchange for protection against losses. While this may be a smart move in certain market conditions, it can also be a hindrance in others.
Expensive to implement: Another weakness of colors is that they can be expensive to implement. This is because the investor has to pay both the protective his put option and the short call option. This cost adds up quickly, depending on the price of the underlying asset and the specific options used.
Requires Active Management: Active management is also required for the collar to be effective. This means that investors must constantly monitor the market and its positions in order to make informed decisions about when to adjust color. This can be time consuming and stressful for some investors.
Although collar strategies are well-known, they have several weaknesses that can limit an investor’s potential returns and require active management. However, there is a lesser-known strategy that can achieve the goal of aggressive hedging without these downsides. These advanced techniques include combining ratioed spreads with butterflies and relying on quadratic Greek indices. As a result, these strategies have several advantages:
Greater Flexibility: These advanced strategies are more flexible than color strategies, allowing more nuanced adjustments to an investor’s position in response to changing market conditions.
Lower cost: These strategies are less expensive to implement than collar strategies, which require the purchase of both protective put options and short call options.
Higher profit potential: By relying on secondary Greek strategies and combining ratio spreads and butterflies, these strategies have higher profit potential than collar strategies.
Reduced need for active management: These advanced strategies require less active management than color strategies. This can benefit busy investors and those who prefer a more hands-off approach.
Although collar strategies occupy their place in certain market conditions, there are advanced options trading strategies that can offer several advantages over collar strategies. These techniques are worth considering by investors interested in actively hedging their positions while maximizing their potential gains.
In conclusion, investing in the stock market can be risky and unpredictable, but options trading can provide a way to proactively hedge against potential market crashes.
Proactive hedging involves taking steps to protect your portfolio before a market downturn occurs. Collar strategies are a well-known technique used for proactive hedging, but they have several weaknesses that can limit an investor’s potential profits and require active management. However, there are advanced options trading strategies that can offer greater flexibility, lower costs, higher profit potential, and reduced need for active management.
Ultimately, investors should consider all options trading strategies to find the one that best suits their risk tolerance, investment objectives, and market conditions. By actively hedging a portfolio, investors can reduce their risk exposure, take advantage of market opportunities and potentially achieve higher returns.
About the author: Karl Domm’s 29+ years of experience in options trading demonstrates a proven ability to trade for a living. His journey started as a retailer, which he finally achieved after struggling for 23 years.
Achieved consistent profitability in 2017 through a proprietary options-only portfolio with quantitative trading strategies.
After building a solid trading track record, he accepted outside investors. His book, A Portfolio for All Markets, focuses on options and his portfolio investments. He earned his bachelor’s degree from Fresno State University and currently lives in Clovis, California.you can follow him on youtube and visit his website real pl for more insight.