To The Moon

The selloff came after Fitch Ratings downgraded U.S. government debt from AAA to AA+ on Aug.1. All three major U.S. Indexes struggled last week, with the $S&P 500(.SPX)$ and the $NASDAQ(.IXIC)$ lost more than 2%, each.

On Aug. 8, Moody's cut credit ratings of several small to mid-sized U.S. Banks, and said it may downgrade some of the nation's biggest lenders, warning that the sector's credit strength will likely be tested by funding risks and weaker profitability.

Some market participants were concerned the signal could spell more trouble for markets ahead, but others say the pullback is expected given the extraordinary rally in equities this year.

Option hedging strategies work best if you're already hedged when the correction arrives. But even if you're late to the game, you still have "options."

Option hedging strategies

Let's review some option strategies that may be useful during a correction or volatile market.

1. Covered Calls (long stock and sell calls)

Selling covered calls can be a good strategy as long as you select a strike price at which you would be willing to allow your holding stock to be called away. The covered call will help generate income during the holding period and lowers the original position’s cost basis.

（Source：Tiger Academy）

A covered call consists of selling a call against shares of holding stock. Typically, covered calls are sold out-of-the-money above the current price of the underlying asset.

However, covered calls do not eliminate downside risk if the asset drops in price, but every covered call sold add credit to the account, thereby reducing the overall cost of holding stock position.

Pros:

• Provides partial (but limited) downside protection

• Can generate a small amount of income

• Time value erosion could be beneficial when the underlying price is stable

Cons:

• Downside protection is limited to the amount of the option premium

• The upside profit potential is substantially limited

• If your short call options go in-the-money, you could be assigned at any time

• Stocks that pay dividends can be especially vulnerable to early assignment

2. Protective puts (long stock and buy puts)

A protective put is purchased when an investor owns an asset and wants to protect against future downside price movement. Owning the long put defines risk by allowing the investor to sell stock at the long put option’s strike price.

Protective puts are similar to purchasing car insurance: a premium is paid to protect against future risk, but the hope is that it will never be needed. Like car owners, investors are willing to pay a relatively small amount on a recurring basis to guarantee defined risk.

（Source：Tiger Academy）

If the underlying asset has increased in price since its purchase, the protective put could be placed above the original purchase price of the stock to secure a profit.

Purchasing a protective put will require paying a premium and will increase the cost basis of the original long stock position. An investor will need to consider these factors when deciding where he or she would like to protect their downside risk and for how long.

Pros:

• Provides significant downside protection

• Has a defined exit price

• Offers potential protection even in a market that gaps down

• Does not require the underlying position to be sold

• Generally allows for unlimited upside profit potential

Cons:

• Require paying a premium, which can be expensive

• Value erodes over time

• Timeframe is limited and the puts may eventually expire worthless

3. Collars (long stock, sell calls/buy puts)

A collar strategy is a multi-leg options strategy combining a covered call and protective put. Selling the covered call will result in a credit that can be used to offset the cost of purchasing the protective put.

The goal of the collar strategy is to fund the cost of the long put with the credit from the sell covered call. A collar strategy combines the downside protection of a protective put with the earning potential of a covered call.

（Source：Tiger Academy）

The collar strategy requires owning or purchasing at least 100 shares of stock and combining the position with a covered call above the stock price and a protective put below the stock price.

The compromise of limiting the upside profit potential is offset by the downside risk protection. The put and call options can be set up at any expiration date and strike price the investor chooses, but the call and put sides of the collar must have the same expiration date and number of contracts.

Collars may be costless or entered for a credit or debit, depending on the strike price of the short call and long put options. Investors typically try to enter a collar at no cost or for a credit, but a small debit is sometimes paid.

Because of the put-call parity in options pricing, a put option with a strike price that is equidistant from the stock as a call option will typically be more expensive. Therefore, if an investor wishes to enter a costless position, they would generally need to have a slight skew in strike prices relative to the underlying stock, where the strike price of the call option is closer to the underlying stock than the strike price of the put option.

Pros:

• Can provide significant downside protection

• Has a defined exit price

• Might offer protection even in a market that gaps down

• Usually does not require the underlying position to be sold

• Can often be set up at little or no cost

Cons:

• Substantially limits the upside profit potential

• If your short call options go in the money, you could be assigned at any time

• Stocks that pay dividends can be especially vulnerable to early assignment

• Timeframe is limited, as the options will eventually expire