Trading Options As Insurance

Options can be traded in their own right, or they can be traded as insurance for another trade (e.g. a stock trade). When options are traded as insurance (also known as hedging), they protect the underlying trade by limiting the amount of potential loss. Trading options as insurance can be very useful, but many traders (especially buy and hold traders) do not understand how options insurance works, and therefore do not use it.

The following discussion provides the basics of trading options as insurance, and explains which options trades are used for which underlying trades. If you are not familiar with options in general, my options basics articles will give you the prerequisite information that you need to understand options insurance.

How Options Insurance Works

Options trades that are made as insurance for another trade are always long options trades (i.e. buying either a call or a put). This gives the options trade limited risk, in that the maximum loss is the cost of the option (i.e. the premium). It is this maximum loss of the options trade that will become the maximum loss of the underlying trade, replacing the potentially unlimited (or at least much larger) loss of the underlying trade.

For example, a long trade on an individual stock could be made by buying one thousand shares at $30. The potential loss for this trade is therefore $30,000 (1000 shares x $30 per share = $30,000). An options insurance trade could be made by buying ten put options (each put option is usually worth 100 shares) with a strike price of $30 (at the money). The ten put options might cost $1,000 (10 options x $100 per option = $1,000). This $1,000 then becomes the maximum potential loss for the combined stock and options trade, instead of the potential $30,000 loss for the stock only trade.

The reason for this dramatic reduction in risk is that the put option allows the holder to sell the stock at the strike price ($30 in this example), regardless of the stock's actual price at the time. If the stock was bought at $30 and can be sold at $30, the stock trade's loss can only be $0 (i.e. break even). Therefore, the maximum possible loss for the combined stock and options trade is $1,000 (i.e. the cost of the options).

How To Make Options Insurance Trades

Basic options insurance trades are always made using long options trades (i.e. buying options), with at the money options. In order to insure a long stock trade, a long put options trade would be used, and to insure a short stock trade, a long call options trade would be used. If this is confusing for you, the following table might explain this more clearly:

Long Stock Trade

• Options Trade: Long
• Type: Put
• Strike Price: At the money (i.e. the same as the stock purchase price)

Short Stock Trade

• Options Trade: Long
• Type: Call
• Strike Price: At the money (i.e. the same as the stock purchase price)

Trading Warrants As Insurance

European and Asian traders can also make options insurance trades using warrants (i.e. warrant insurance trades). Warrants have lower premiums than options, and are therefore the preferred way to make insurance trades for non US traders.

Making insurance trades using warrants is essentially identical to making insurance trades using options, but the differences between options and warrants need to be taken into account. For example, one difference between options and warrants is that warrant multipliers are used slightly differently from options multipliers. My introduction to warrants explains the basics of trading warrants, and should provide enough information for warrants to be used for insurance trades.