In our first post on hedging we talked about using an ultra short ETF (Exchange Traded Fund) as a beginner hedging strategy. Put options can be used as a more advanced hedging strategy to protect your stock portfolio from a stock market crash or econmic recession. They can also be called a protective put if you own the underlying stock or ETF.

Buying a put means that you are paying a premium (price of the option) for the option to sell a specific stock or ETF at a strike price (specified price you can sell at). Option contracts have an expiration date which is the third Friday of the month specified in the options contract, or Thursday if Friday is a holiday. If the price of the underlying stock or ETF drops below the strike price before the expiration date, you can exercise your put option contracts. Exercising put options will sell 100 shares per option at the strike price. If you don't own the stock or ETF and you exercise your put options, your broker should automatically purchase the stock or ETF at market price and sell it at the strike price. If you don't execute your put options and they expire "in the money" (the strike price is above the market price), your broker should automatically settle the options for cash. To make money with a put, the market price of the stock or ETF has to fall below the strike price minus the premium you paid.

You can also sell options you own before the expiration date. Selling put options that you own is a great way to recover money when the underlying stock or ETF is increasing in price. An option contract represents 100 shares, so 5 put options gives you the option to sell 500 shares at the strike price before the expiration date. Options are quoted at the price per one share even though they are sold in lots of 100. An option that is quoting $1.50 would cost you $150 for one option. Options can often expire worthless which means there is a strong possibility you'll lose the money you spent to purchase the put options.

For portfolio protection we recommend purchasing a put on an index ETF. The SPY is a great ETF for the S&P 500 and the QQQQ for the Nasdaq 100. Buying a put option for the SPY or QQQQ helps protect you against a crash in the S&P 500 or Nasdaq 100 respectively.

Advantages of using Puts for a Hedge
Less expensive then an ultra short ETF for similar protection
More protection in the case of a market crash or recession

Disadvantages of using Puts for a Hedge
Time frame - ETF's don't expire
Very risky - easy to lose all the money you invest in the put

Make sure you understand how options work before you hedge with puts. There are a lot of advanced concepts involved with options and it’s very important to understand options extremely well before you use them. If you are unsure about using options please use the ultra short ETF’s we mentioned in our previous post on protecting your portfolio. Ultra short ETF's are much easier to use because they are usually less volatile and don't have an expiration date.

More from Market Flavor on Portfolio Protection and Hedging.

Links to more information on puts.
Great CNBC article on hedging with puts.
Great article about options from the Chicago Board of Trade.
Investopedia article on hedging.
Description of protective puts.
FAQ article on exercising option.