Overnight, the US stock market fell sharply, Magnificent Seven was sold due to poor performance.
The $S&P 500(.SPX)$ plunged 2.32%, marking its worst single-day performance since December 2022. For the first time in 356 trading days, it closed with a loss exceeding 2%, breaking the record of 365 consecutive trading days since 2007 without a 2% or more drop. The $NASDAQ(.IXIC)$ also took a hard hit, falling 3.64%, its steepest one-day drop since October 2022, and closing at its lowest point since June 10. The $DJIA(.DJI)$ dipped 1.25%, ending below 40,000 points for the first time in two weeks.
Looking at individual stocks, the "Magnificent Seven" has evaporated by more than $760 billion market value. $Tesla Motors(TSLA)$ tanked over 12%, the largest one-day decline since September 2020, the total market value fell below $700 billion. $NVIDIA Corp(NVDA)$ slipped by more than 6%.
At this moment, investors are crying out for effective hedging and shorting tools. Here are six commonly used options strategies that can serve as a reference for investors seeking protection.
I. Buying Put Options
Buying put options serves dual purposes: primarily for shorting the market, and secondly, as a risk management strategy to safeguard against losses in held stocks or assets. The latter form is commonly known as a Protective Put.
Buying put options alone is a bearish strategy, where traders anticipate the asset price to fall. The Protective Put strategy, on the other hand, is combined with owning stocks, ideal for investors who remain bullish on a particular stock but wish to hedge against potential losses and uncertainties.
Put options can be used for shorting, while Protective Puts can be applied to stocks, currencies, commodities, and indices, offering downside protection when asset prices decline.
II. Covered Call Strategy
Apart from buying put options, investors can also hedge against market downturns by selling call options. When investors hold the underlying stock, this strategy is known as a Covered Call. It involves selling call options on the stock you already own.
Covered Calls: How They Work and How to Use Them in Investing
The Covered Call strategy is typically suitable for investors who have a long-term bullish on their holdings but don't want to sell their shares, expecting the stock price to remain stable without significant surges or plunges. This strategy can also effectively hedge against minor market declines. Additionally, if investors choose to sell out-of-the-money call options, the hedging effect will be similar to buying put options.
III. Bear Spread Strategy
The bear spread strategy is designed for options traders who anticipate a decline in the underlying asset's price over a certain period and wish to short the asset while limiting their risk exposure. Both Call and Put options can be used to construct a Bear Spread, which is generally called a Bear Call Spread if a call option is used, and a Bear Put Spread if a put option is used.
Bear Call Spread: Overview and Examples of the Option Strategy
Specifically, a Bear Call Spread involves buying call options at a specific strike price and simultaneously selling the same number of call options with the same expiration date but at a lower strike price.A Bear Put Spread, on the other hand, involves buying put options at a specific strike price and selling an equal number of put options with the same expiration date but at a lower strike price.
The primary advantage of the bear spread is that it reduces the risk associated with shorting (buying a call at a higher strike price helps offset the risk of selling a call at a lower strike price). Direct shorting of stocks can theoretically have unlimited risk if the stock price rises, but using a Bear Call Spread significantly mitigates this risk. Furthermore, combining options with different expiration dates can transform the strategy into a calendar spread, among others.
IV. Reverse Ratio Spread
The disadvantage of the traditional spread method is that although the risk is limited when going long or short, the upward and downward profits are also limited. A reverse ratio spread addresses this by offering unlimited profits with limited risk.
In a reverse ratio spread strategy, traders buy at-the-money (ATM) or out-of-the-money (OTM) call or put options and sell at least two or more identical OTM options. If traders are bearish, they will use a put reverse ratio spread.
A put reverse ratio spread, also known as a defensive bear spread, involves selling one put option with a higher strike price and buying two put options with the same expiration date but a lower strike price, in a 2:1 ratio. This strategy accelerates profits in a significant stock price decline and still generates some profits if the stock rises rapidly, making it suitable for investors with a pessimistic outlook on market movements.
V. Collar Strategy
Protecting downside risk in stocks involves buying protective put options, while reducing the cost of holding stocks can be achieved through selling covered call options. To balance both, the Collar strategy was born.
How a Protective Collar Options Strategy Works
The Collar strategy involves owning stocks, purchasing an out-of-the-money (OTM) put option as insurance, and simultaneously selling an OTM call option to cover the cost of the insurance. It's like putting a collar around your stocks, locking in their potential gains within a range, hence the name. Essentially, a Collar combines a Protective Put and a Covered Call, limiting downside risk at the cost of sacrificing some upside potential.
When traders have a bullish position in the market and want to protect it from downside shocks, the Collar strategy comes in handy. When the full cost of the put option is covered by selling the call option, it's known as a zero-cost collar strategy.
VI. Volatility VIX and Leveraged ETFs
Investors often turn to the Volatility Index (VIX) for a read on market sentiment during turbulent times. Dubbed the "Fear Index," VIX typically spikes during sharp market declines. Investors can also trade futures and options on VIX for hedging purposes.
If investors anticipate further steep market declines, they can hedge by buying VIX call options. Conversely, if they believe the market will stabilize and rebound, they can profit by shorting VIX through options.
Investors can also leverage options on leveraged ETFs to enhance their hedging strategies.
VII. Conclusion
In summary, if investors think the market will continue to plummet, they can hedge using put options, reverse ratio spreads, bear spreads, or buying VIX call options. Among these, the reverse ratio spread offers limited risk and unlimited profit potential, bear spreads are cost-effective, and buying VIX call options provides the best hedging effect in specific scenarios.
For investors expecting a stable or slightly declining market, selling call options or employing the Collar strategy are viable options. Selling call options offers more upside potential when stocks rise, while the Collar strategy preserves upside potential while capping downside risk.
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