Protect Against the Downside With This Strategy

Selling options is one way to generate additional income for your portfolio. By collecting premiums from the trades over and over, you can create a nice additional cash flow stream.

The potential downside to selling options, however, is similar to shorting. When you buy an option, the most you could lose is 100%—the premium you paid. But when you are short and the risk isn’t properly managed, if things go badly against you, you could end up losing a lot more than the premium you collected. Thus, many option traders will use multi-legged option trades to hedge in order to limit risk.

The Drawback to Stop-Loss Orders

One way to hedge against a big loss without needing to watch your portfolio all the time is to set a stop-loss order. This order is triggered when the option price goes above a price you set. However, this order becomes a market order when it’s triggered, so if the option price is rising rapidly, you could still end up buying back the option at a much higher price than you set.

Alternatively, you could go with a stop-limit order so that you won’t buy at anything higher than the limit price you pick, but that could result in the order not filling. In this case you would still hold onto the position while the option price keeps increasing, which is bad for you since you are short.

Here’s where the multi-legged trade strategy is superior to a stop-loss order. It’s possible to structure your trade so that you can limit your potential loss to a maximum amount no matter what happens. Here’s an example.

The Bull Put Spread

Let’s say you aren’t a big fan of Tesla (NSDQ: TSLA), but you like the June $160 put for $11.85. If TSLA ends up at $160 or better at expiration ($160 represents roughly a 12% decline from the current price as of this writing), the option will expire worthless. Even if TSLA falls under $160 and the stock is put to you, you could still have a gain as long as the market price is $148.15 or better.

You feel pretty good that TSLA will be ok, but you also know that the stock has been as low as $101. 81 in the past 52 weeks so you decide to hedge via a spread. To do so, you can buy another put with the same expiration date as the one you sold, but with a lower strike price. If you buy the June $150 put for $8.75, you will have capped your maximum potential loss at $690.

Protection Against Potential Disaster

If TSLA fell overnight to, say, $120, if you didn’t have the hedge in place, you could be put 100 shares of the stock at $160 and you would be down $4,000 off the bat—($160 – $120) x 100. But since you are also long the $150 put, you can turn around and sell to the counterparty at $150. You lose $10 per share ($1,000 total) in the transaction, but it’s partially offset by the $ 310 credit from the spread, so overall your loss would be $1,000 – $310 = $690. Note that even if Tesla fell to zero, as long as you still have the $150 put open, you can keep your loss capped at $690.

The graph shows the gain and loss for the spread at different prices of TSLA assuming both legs are held to maturity. If you close one or both legs before expiration, your actual return would likely differ from what’s shown in the chart.

The downside to this spread strategy is that it will cap your potential maximum gain at $310—when both legs expire worthless. Again, that’s assuming you hold both put positions to maturity.

If you’re thinking to yourself that the maximum gain of $310 feels like a bad deal against the maximum downside of $690, keep in mind that having the hedge in place is a psychological safety net. No matter how far TSLA falls, you are guaranteed to be able to sell it at $150 a share. This can take emotion out of your trading decision and help you make better decisions. You can always exit either or both positions before expiration if it gets you a better gain.

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