The stock market is known for rising during both times of euphoria and fear. For instance, the stock market hit record highs during the COVID-19 pandemic despite extremely high levels of unemployment, a sharp contraction in gross domestic product and lofty equity valuations.
Investors that continue to hold stocks during these times may worry about a sudden downturn wiping out their portfolio. Fortunately, there are several options strategies that can help investors hedge against downside risk while maintaining exposure to the stock market.
Let’s take a look at how married puts can help you hedge against near-term risks as well as some other alternatives that you may want to consider.
What Is a Married Put?
The married put options strategy involves buying an at-the-money put option while simultaneously purchasing (or holding) an equivalent amount of underlying stock. Since put options provide the right to sell at a specified price, the strategy effectively establishes a price floor for a long stock position while retaining its unlimited upside potential.
Married Put Payoff Diagram – Source: The Options Guide
The economics of the strategy are pretty straightforward:
- The breakeven point is equal to the purchase price of the underlying stock plus the premium paid for the put option.
- The max loss for the position is equal to the put option premium plus any commissions.
- The max gains are uncapped since the underlying stock has unlimited upside and the put can expire worthless.
- The investor continues to accrue dividends and maintains voting rights.
The cost of the married put depends on the underlying stock. Of course, high-risk markets or volatile stocks will typically involve higher premiums, making the insurance more expensive to purchase. Investors must carefully consider these tradeoffs when deciding whether to purchase downside protection or simply sell the stock and stay out of the market.
Examples of Married Puts
Suppose that you’re bullish on a stock but worry about near-term uncertainties. In order to establish a married put, you purchase 100 shares of stock at $50.00 and purchase one put option with a $50 strike price for $2.00 ($200). The strategy enables you to limit losses to just $200 while still benefiting from the upside potential of the long stock position.
Let’s take a look at a few different possibilities:
- There is a severe market contraction and the stock falls to $25.00. In that case, you would only lose $200 (the premium paid for the put option) rather than $2,500 (the $5,000 initial position minus the $2,500 loss in value).
- There is a significant market rally and the stock rises to $75.00. In that case, you would still capture $2,300 in upside (the $2,500 increase minus the $200 premium for the put option).
- The stock stays at $25.00 and nothing happens. In that case, you would lose $200 (the premium for the put option). The benefit in this case is that you wouldn’t have to worry about a sharp decline in the market while the position was in place.
Alternative Ways to Protect
The married put strategy is just one of many options strategies that can hedge your portfolio against downside risk while maintaining upside potential.
Some of the most common alternatives include:
- Protective puts are similar to married puts but don’t necessarily completely cover the long stock position. For example, you may purchase one put option for 200 shares of stock to offset just part of any decline or use out-of-the-money puts to protect against only extreme moves in the underlying stock price.
- Long calls involve purchasing a call option in lieu of holding underlying stock. While losses are limited to the cost of the call option, investors can exercise the call option at a set price and realize unlimited upside. Of course, option holders don’t receive dividends and don’t have any voting rights associated with holding stock.
- Call backspreads involve selling one in-the-money call option and buying two out-of-the-money call options. The resulting position has unlimited profit potential and a loss that’s limited to the difference between the strike price of the long call and the short call plus or minus the net premium paid/received plus any commissions.
- Collars are out-of-the-money covered calls that are pared with the purchase of an additional protective put. It’s a good strategy to use if holder is writing covered calls to earn income, but want protection from an unexpected sharp decline in the stock price.
Generating Income with Options
Married puts, protective puts, long calls and backspreads are all great ways to hedge a portfolio against downside risk, but fail to generate income for investors in retirement. This becomes critically important for retirees living off their portfolio and taking regular monthly withdrawals. Covered calls are an options strategy designed to generate extra income from a stock portfolio with downside risk that’s limited to the underlying stock performance.
For example, suppose that you’re in retirement and rely on portfolio income. Fixed income investments have become risky with interest rates near historic lows while many stocks have had their dividends cut to preserve cash. Covered calls enable you to generate an extra income from your portfolio to fund your retirement.
The Snider Investment Method simplifies the process of identifying attractive covered call opportunities with minimal time spent maintaining a portfolio. By holding high-quality stocks, investors can avoid many of the risks associated with options-only strategies and capture meaningful upside while still generating greater income than possible with dividends alone.
The Bottom Line
Married puts are a great way to hedge against losses while retaining the upside potential of a long stock position. By purchasing an at-the-money put alongside a long stock position, you can create a price floor that minimizes the risk of a near-term decline. However, when used regularly over an extended period of time, the insurance created by a married put can become very expensive. There are also several similar strategies, such as protective puts, long calls and call backspreads.
If you’re interested in generating an income from your portfolio, covered calls can help generate income above and beyond simple dividends. Take our free e-course to learn more!