Option one: Protective Put Strategy
While numerous investors might be cowering under the heat of a market selloff, options traders can utilize the current climate to implement a protective put strategy. This strategy, which has perennially been proven to instill confidence in times of market uncertainty, involves buying put options for an asset that an investor already owns.
As a refresher, a put option grants the holder the right (but not obligation), to sell a specified quantity of a security at a specified strike price within a fixed period. Essentially, investors buy a put option to shield themselves from potential losses that may be suffered if the stock price plummets.
In the context of a market selloff, a protective put strategy enables investors to set a specific selling price for their stocks. If the market price of the security drops, the investor profits from the put option, thus offsetting the loss in the underlying stock. On the other hand, if the market price of the security stays the same or rises, the investor only loses the premium paid for the put option, essentially a small fee for risk protection.
Investors should keep in mind, though, that while a protective put strategy reduces the risk of holding a stock by offering downside protection, it also caps upside potential due to the premium expense. Thus, this approach is best suited for conservative investors seeking to protect their portfolios against excessive fallout in a markets selloff.
Option two: Selling Covered Calls
Another options strategy that can be beneficial during a market selloff is selling covered calls. In this scenario, an investor sells call options for an underlying asset already in their possession. A call option is a contract that gives the holder the right (but again, not the obligation), to buy a specified quantity of a security at a predetermined price within a set period.
With a covered call strategy, an investor can generate additional income through the premiums received from selling the call options. This income adds a buffer to their portfolio, which can neutralize the negative impact of descending stock prices during a selloff.
Executing the covered call strategy during a market selloff presents advantages. The more fearful investors become, the higher the implied volatility — a significant component of options pricing — which in turn increases the premium of options contracts. Therefore, selling covered calls in such conditions can fetch higher premiums for options contracts, providing greater income and protection to the portfolio.
Though it is critical to discuss its limitations: while it offers a buffer against small declines, selling covered calls, unlike the protective put strategy, does not provide protection if the stock’s price drops significantly. Furthermore, this strategy restricts upside potential if the price of the stock unexpectedly surges, as the seller of the call is obliged to sell the stock at the strike price.
In conclusion, bearish markets may initially seem like frightening territories to venture into, but equipped with knowledge about use of protective put and covered call strategies, investors can successfully navigate the tumultuous times and even find opportunities to profit. By understanding the dynamics of Options, and when to implement them appropriately, investors can effectively shield their portfolios during a market selloff.
