Hedging refers to the practice of making investments or entering into positions specifically designed to offset potential losses in other investments. The primary objective behind hedging is to protect the investor’s portfolio from downside risks and uncertain market fluctuations. Hedging techniques provide investors with the confidence to pursue investments that may carry significant risks.

One effective strategy used for hedging a stock portfolio is utilising put options. Put options offer investors the opportunity to limit downside risk. By purchasing a put option, an investor secures the right to sell a specific number of shares at a predetermined price, known as the strike price, before or upon the option’s expiry date. The strategy acts as a defensive mechanism to protect against unfavourable market conditions and unforeseen events.

The Benefits of Hedging with Put Options

• Risk Mitigation: Hedging a stock portfolio with put options provides investors with a form of insurance against potential market declines. In the event of a significant drop in stock prices, the holder of the put option can sell at the higher strike price, thereby offsetting losses incurred in the stock portfolio.
• High Degree of Flexibility: Investors can select the number of put options needed based on the size of their stock portfolio, thus tailoring the hedge to their specific risk tolerance levels.
• Cost-Efficient: Hedging with put options can be a cost-efficient method compared to other hedging strategies. Purchasing put options typically requires less capital outlay than selling off shares or short selling.
• Speculative Opportunities: Apart from hedging, put options can also be used for speculative purposes, offering the potential for profit from market downturns.

The Disadvantages of Hedging with Put Options

• Premium Costs: Acquiring put options involves paying a premium, which is the cost of the hedge. While this premium may be lower than other hedging alternatives, it still represents an additional expense.
• Time Decay: Put options have an expiration date, and their value diminishes over time. If the market does not move as anticipated, the option could expire worthless, leading to a loss of the premium paid.
• Limited Profit Potential: If the stock price rises significantly, gains in the portfolio may be offset by the cost of the put options. It is crucial to strike a balance between protecting against loss and allowing for potential growth.
• Complexity: The pricing and management of put options can be complex, requiring a thorough understanding of market dynamics and risk management concepts. Investors need to be knowledgeable about factors such as implied volatility, interest rates, and the relationship between the underlying stock and the option price.

When purchasing put options to protect stock positions, investors should strive to keep premiums affordable. Several key considerations to ensure put premiums on stocks are not overly expensive include:

• Evaluate the Time Horizon: The duration of the put option contract plays an essential role in determining the put premium. Longer-dated options tend to have higher premiums due to increased time value. Investors interested in affordable put premiums should carefully evaluate the desired time horizon for the stock protection they seek. Selecting a put option with a relatively shorter time to expiration may result in a reduction in the premium price.
• Analyse Implied Volatility: Implied volatility refers to the market’s expectation of future stock price volatility. It significantly impacts the pricing of put options. When implied volatility is high, put premiums become more expensive. Investors can monitor the implied volatility levels of specific stocks or use industry-standard volatility indices, such as the CBOE Volatility Index (VIX), to gauge market sentiment. By purchasing put options during periods of relatively lower implied volatility, investors can potentially secure more affordable premiums.
• Tax Implications: As with all investments, make sure you seek advice on any tax implications for your hedging strategy, which may be beneficial or carry additional costs.

Borrowing against a share portfolio

• Put Options: A protected stock portfolio can also provide investors with increased flexibility. As discussed, investors that effectively protect their share portfolios with put options, and have the comfort of limiting downside movements in prices. This reduction in risk enables many investors to borrow against the underlying investments with no margin calls.
• NAB’s Protected Equity Loan (PEL): A borrowing facility that enables investors to borrow up to 100% of their underlying investment portfolio without margin calls. The PEL may be suitable for Wholesale investors who are looking to invest in ASX listed shares or may be considering investment strategies that involve negative gearing. To find out more about NAB Equity Options and Approved Options contact your NAB Private Wealth representative.

Conclusion

Hedging a stock portfolio with put options offers investors a range of benefits, including risk mitigation, flexibility, cost efficiency, and speculative opportunities. However, it is essential to consider the drawbacks, such as premium costs, time decay, limited profit potential, and the complexity involved. Investors should carefully assess their risk appetite, investment goals, and market conditions before employing put options as a hedging strategy. Seeking professional advice can further enhance their understanding and decision-making in utilising put options effectively.

Important information

The information contained in this article is gathered from multiple sources believed to be reliable as at March 2024 and is intended to be of a general nature only. It has been prepared without taking into account any person’s objectives, financial situation or needs. NAB does not guarantee the accuracy or reliability of any information in this article which is stated or provided by a third party. Before acting on this information, NAB recommends that you consider whether it is appropriate for your circumstances. NAB recommends that you seek independent legal, property, financial and taxation advice before acting on any information in this article. ©2024 NAB Private Wealth is a division of National Australia Bank Limited ABN 12 004 044 937 AFSL and Australian Credit Licence 230686