How to Hedge Selling a Put Option

Selling a put option can be a great way to generate income, but it comes with risks—most notably the risk of being forced to buy the underlying asset at the strike price if the option is exercised and the market price falls. In this article, we will explore how to hedge selling a put option, offering practical strategies that can help mitigate potential losses while maintaining the upside.

The Key Question: How Do You Protect Yourself from the Risk of Selling a Put Option?

When you sell a put option, you are agreeing to buy the underlying stock or asset at a certain strike price if the buyer decides to exercise their option. While you earn a premium for selling the option, you're exposed to potentially large losses if the asset price falls significantly. So, what can you do to protect yourself? There are a variety of strategies that experienced traders use to hedge against these risks, which we'll discuss in detail below.

Hedging Strategies for Selling a Put Option

1. Covered Puts
   One way to hedge against the risk of selling a put option is to use a covered put strategy. This involves shorting the underlying stock that you’ve sold the put option for. In simple terms, you are both selling a put option and shorting the stock, which can offset potential losses if the stock's price declines. However, this strategy may limit your gains if the stock's price increases, as you'd lose on your short position.

   For example, if you sell a put option on XYZ stock with a strike price of $50 and the current price is $55, you could short XYZ stock. If XYZ falls to $45 and the put option is exercised, you’ll be forced to buy XYZ at $50, but since you’ve already shorted the stock, the losses are mitigated.

2. Protective Puts
   Another popular strategy is to buy a protective put on the same underlying asset for which you’ve sold the put. A protective put acts like insurance. If the underlying asset's price falls, the protective put can limit your losses, since you have the right to sell the stock at a predetermined price.

   This strategy is similar to a married put, but in this case, you're doing it in reverse. You're selling a put to generate income while buying a put to hedge against downside risk. The cost of buying the protective put is typically lower than the premium earned from selling the put, making this a cost-effective hedging option.

   For example, if you've sold a put option on XYZ stock at a strike price of $50 and also bought a protective put with a strike price of $45, the protective put will limit your losses if the stock price drops below $45. While you’re still obligated to buy the stock at $50 if the put is exercised, the protective put limits your downside.

3. Delta Hedging with Futures or Options Delta hedging involves using futures or options contracts to neutralize your delta exposure from selling a put option. Delta measures the sensitivity of an option's price to changes in the price of the underlying asset. If you’re short a put option, your delta is negative, meaning the value of your position will increase as the underlying asset’s price falls. You can neutralize this delta by taking a long position in the underlying asset, or in a future or option with an offsetting delta.

   Delta hedging is a dynamic strategy, meaning it requires frequent adjustments as the price of the underlying asset moves. This can make it a bit more complex to execute, but it offers the advantage of continually balancing the risks of your short put position.

   A common method of delta hedging is to purchase call options or shares of the underlying stock as the price moves lower. The exact amount you need to buy is determined by the delta of the put option you've sold. This method ensures that you won't face unlimited losses if the stock price plummets.

4. Vertical Spreads
   A vertical spread is another effective way to hedge the risks associated with selling a put option. Specifically, a bull put spread involves selling a put option while simultaneously buying a put with a lower strike price on the same underlying asset. This reduces the premium you receive, but it also caps your potential losses. If the price of the underlying asset falls, the put you purchased will offset losses from the put you sold.

   Here’s an example: Say you sell a put option on XYZ stock with a strike price of $50 and receive a premium of $2. At the same time, you buy a put with a strike price of $45 for $1. The net premium received is $1, but your potential losses are capped at $5 (the difference between the two strike prices) minus the premium received.

5. Rolling the Option
   If the price of the underlying asset drops and you believe it may recover, rolling the option is another technique to hedge against losses. Rolling involves closing your current short put position and opening a new short put position with a later expiration date and potentially a different strike price. The idea is to give the underlying asset more time to recover before the option expires.

   For example, if you sold a put option on XYZ stock at a strike price of $50 that is about to be exercised, you could buy back the put and sell a new put with the same strike price or lower, but with an expiration date further out in the future. This gives the stock more time to recover and allows you to avoid immediate losses.

When Should You Hedge a Short Put Position?

While it’s tempting to think of hedging as something you should always do, it's important to recognize that hedging strategies can sometimes reduce your overall profits. They are best used in scenarios where you expect significant downside risk or increased volatility in the underlying asset.

Key situations to consider hedging include:

• High market volatility: When the market is highly volatile, the underlying stock could drop suddenly. A hedge in this case can protect your position.
• Macro-economic risks: Events like economic downturns, interest rate hikes, or geopolitical instability can negatively impact stock prices. Hedging can provide peace of mind in such uncertain times.
• When the stock price approaches the strike price: If the underlying stock is nearing the strike price of your sold put option, hedging might be a smart move to protect against a further decline.

Pros and Cons of Hedging

Hedging against selling put options can protect against losses, but it’s not without its trade-offs.

Pros:

• Limits losses: The primary advantage of hedging is that it limits potential losses if the underlying asset falls in price.
• Flexibility: With strategies like vertical spreads or delta hedging, you can customize your risk exposure.
• Peace of mind: Knowing that your position is protected allows you to trade with more confidence.

Cons:

• Reduced profits: Most hedging strategies will reduce the premium you receive from selling the put, meaning lower profits if the trade goes in your favor.
• Complexity: Some strategies, like delta hedging, require constant adjustments and a deep understanding of options trading.
• Costs: Buying protective puts or setting up spreads can cost money, cutting into your overall returns.

Practical Example: Hedging a Short Put on Tesla (TSLA)

Let’s walk through a hypothetical example to make this more concrete.

Imagine you sold a put option on Tesla (TSLA) with a strike price of $700. You received a premium of $30 per share. TSLA is trading at $720, so things are looking good—until the stock price starts to drop.

If TSLA’s price begins to fall toward $700, you might decide to hedge. You could:

• Buy a protective put with a $650 strike price. If TSLA drops below $650, this put will protect your downside.
• Roll the option by buying back the $700 put and selling a new one with a strike price of $680, extending the expiration date by a few months.
• Delta hedge by purchasing TSLA shares as its price drops, reducing your net exposure.

Each of these strategies offers a way to protect your profits and limit potential losses.

Conclusion: The Right Hedge for You

The ideal hedging strategy depends on your risk tolerance, market view, and how active you want to be in managing your portfolio. Some traders are comfortable with the risks of selling put options without hedging, relying on careful stock selection and market timing. Others prefer the safety of strategies like vertical spreads, protective puts, or delta hedging to reduce their risk exposure.

The important thing to remember is that no hedge is foolproof. While these strategies can help limit losses, they can also reduce profits. Balancing risk and reward is key to successful options trading.