As another round of rotation seems to be underway, it’s worth exploring how to protect holdings from large drops in price. Here’s how to use put options on the SPDR Dow Jones ETF (DIA) as a hedge.
Readers of the news lately might get the idea from wallstreetbets followers that the purpose of options is for high-octane speculation. Actually, the original purpose of options was as an instrument to hedge investments. Buying put options allows investors to maintain ownership of their stocks while protecting the downside.
If you are going to try and hedge your portfolio, you need to select an instrument that correlates well to what you are trying to protect. If you have more of a blue-chip focus in your investments, put options on the Dow Jones ETF would be a good starting point as a hedge.
As a reminder, a put option is a financial contract that gives the holder the right, but not the obligation, to sell a certain underlying asset at a certain price on or before expiration.
For this right, the buyer of the put option pays a premium to the option seller. Think of it as buying insurance against your house burning down.
You as the homeowner pay the insurance premium. The options seller is like the insurance company. He receives the premium but takes on risk should the asset decline.
Owning a put option gives the owner the right to sell their stock at a certain price, no matter how low it goes. The downside is protected while the investor still gets to benefit in the upside.
Using Put Options For A Dow Jones Hedge
Assume we own a portfolio of blue chip stocks correlated to the Dow Jones index. What if you don’t want to sell but are concerned about the short-term prospects.
Instead of liquidating our portfolio, we could buy put options on the Dow Jones ETF to help cushion the effects of any downturn.
With this rotation, the Dow Jones index dropped below both its 21-day exponential moving average and 50-day line.
With the SPDR Dow Jones ETF trading around 341, an August 20 expiration put with a strike price of 330 could be purchased for around $5.20 per contract.
That would be $520 in total for a block of 100 shares.
The break-even price for the put option would be 324.80 and can be calculated by taking the strike price (330) and subtracting the premium paid (5.20).
Buying some protection like this can be expensive, but it can also help us sleep a little better at night if we are concerned about a large drop in stocks over the next two months.
This August 330 put option on the Dow Jones ETF has a notional delta of -11,200. That simply means that it will roughly hedge the price risk of a $12,000 portfolio of blue chip stocks.
Choose Your Instrument Wisely
However, it is never perfect. You could find yourself in a position where the stocks you own drop even though the Dow Jones ETF rallies. In that case the hedge wouldn’t work as intended.
It’s important to choose the right instrument for your hedge. Traders with a large proportion of tech stocks in their portfolio may prefer to buy puts on Nasdaq QQQ Trust ETF (QQQ).
The other possibility is buying put options on each specific stock in a portfolio, but that can be costly and time consuming.
Remember options are risky. Investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions. Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
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View more information: https://www.investors.com/research/options/using-put-options-as-hedge-for-dow-jones-exposure/