How to Buy a Put to Hedge Against Loss

A put option can protect against losses in an underlying stock.

Hedging is a trading strategy that involves investing in an asset to offset possible losses in another investment. If you own stock in a company and you want to hedge against loss in case the price of that stock goes down, you can buy a put option on the same stock. A put option gives you, the buyer, the right but not the obligation to sell a stock at some time in the future at an agreed-upon price, known as the strike price or exercise price. A put option is a financial derivative, which means that its value is “derived” from that of some other asset; in the case of a stock option such as a put, the underlying asset is the stock itself.

Instructions

1. Set up a brokerage account that allows you to trade stock options. You can open an account with a traditional broker such as Fidelity or Vanguard, or with an online broker like TD Ameritrade or E*Trade. Compare account minimums, fees for making trades, service fees and other charges. You'll typically pay less in fees with an online broker, but you won’t get the full range of investment advice and attention that you would with a traditional broker.

2. Learn how put options work. A put option is a contract to sell 100 shares of a particular stock; the fee you pay to buy the contract is called the premium. If you buy one put option with a strike price of $125 a share and the underlying stock goes down to $115 a share, you can still sell 100 shares of that stock at $125 each; you’ve made $10 a share. If the stock goes up to $135 a share, you'd still be able to sell your shares for only $125 each, so you'd lose $10 a share; in this case, the option has no value. Because you're not obligated to sell, however, the only thing you'll lose is the premium you paid to buy the contract.

3. Hedge against a loss on a stock you already own. Let’s say you’re holding 100 shares of Microsoft. Microsoft has appreciated considerably, but you think it still has room to go up some more, so you don’t want to sell; on the other hand, you’re afraid the stock may go down. If Microsoft is selling for $100 a share, you could buy a put with a strike price of $98 a share. If the shares continue to go up, you’ve lost only the premium you paid for the put option. If the stock goes down dramatically, you can still sell 100 shares for $98 a share; you've limited your loss on the underlying stock to $2 a share.

4. Pay attention to expiration dates and stock prices. Put options typically expire within one month to two years after the date of purchase. If you don’t exercise your options before the expiration date, they expire and become worthless. If your underlying stock is going down and the expiration date on your options contract is approaching, then exercise your option to sell.

Tips & Warnings

• When the strike price of the put option is above that of the underlying security, the option is “in the money.”

• You don’t have to sell the stock itself; you can instead sell the options contract.

• Another type of stock option is the call, which gives the buyer the right, but not the obligation, to buy a security in the future at a specified strike price.

• The pricing of stock options is complex. The premium on a put or a call depends on the price of the underlying stock, the strike price of the option and the time until expiration.

References

• Financial Industry Regulatory Authority: What to Expect When You Open a Brokerage Account
• TD Ameritrade: Options Trading
• OptionTradingpedia.com: Hedging
• 888options.com: Options Strategies in a Bull Market Course
• The Motley Fool: Insure Your Portfolio Against Huge Losses
• The Options Guide: Put Option