How to Use a Put Option Overlay to Minimize Market Risk

It was a rough start for stocks. January was the worst month for the S&P 500 since March 2020. Lately I’ve been fielding more calls from clients about what do with their stock investments. Some are worried they will lose the gains they built up over the years. Others may be getting closer to retirement and not sure if they want to be in the stock market. For these investors, I am sharing with them another option: a put option, that is.

What is a put option?

A put option is a contract that gives the owner the right to sell a stock at a specified price anytime before a certain date. Investors use put options to hedge against market declines. A put option can rise in value as the stock loses value. If you buy a put option to sell XYZ stock in the future for $86, and the stock price drops to $66, the put option – or right to sell at $86 – is profitable. The opposite is true too, if the stock price rallies, a put option can lose money.

How a put option works

An investor buys out-of-the-money put options using existing portfolio as collateral. This gives them the right to sell their equity holdings at a specified price in the future. To minimize the cost of purchasing the put options, out-of-the-money put options can be sold. Selling options provides income. This income is used to buy the aforementioned put options. Investors can also sell out-of-the-money call options to help offset the premium of buying the put option. A call option works the opposite of a put option – it is the right to buy a stock or mutual fund at a specified price in the future.

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Buying a put option provides some downside protection, because if the market plummets, you make money (of course if the market skyrockets, you lose money on the put – but the rest of your portfolio should rise). The put and call options sold generate income to pay for the puts. The goal is we can provide significant downside protection, without selling our underlying stock positions, and with minimal cost.

For example, in one client’s case, we set up a put option overlay providing full equity downside protection between negative 5% and negative 20%. This means an equity investor is subject to the first 5% drop in value, but completely protected if the value drops within that -5% to -20% range.

The tradeoffs of put options

There are pros and cons to every investment decision. Though we are describing a costless options strategy, selling and buying options to minimize the out-of-pocket investor cost, there still may be a small incremental cost.

Another downside to a put overlay is it limits our upside. If the stock market is up 30%, an equity portfolio with a put overlay is up less, maybe only 10%-12%, hypothetically speaking. Also, a put overlay may not fully protect the equity investor. In this example, the client is exposed to the first 5% drop in value. Protection kicks in from -5% to -20%. If the stock market breaks through significantly, down 30%, the client is exposed, in this example potentially down 15%. If the client wants more downside protection, other option strategies may make sense, like a “collaring” strategy. Generally speaking, with options, the more downside protection, the more we limit the upside.

Final thoughts

Options are not suitable for everyone. They are complicated and have certain tax ramifications. However, they do serve a purpose. In this case, adding a put overlay strategy is one way to minimize the downside on an existing equity position.

The put option overlay is for investors who don’t want to give up on the stock market entirely – meaning they want some upside – but also want to minimize their downside.

What I provided here is a basic, generalized description, of one strategy using options. There is much more to know, so be sure to consult with a qualified adviser. If you would like to learn more, please email me at maloi@sfr1.com.