Protective Puts and Collars

A hedge is not a trade — it is a decision about what you refuse to lose. Before you buy any protection, answer three questions in plain words.

First: what are you protecting? One stock you love? Your whole portfolio? A specific dollar amount you cannot afford to lose? Second: how much loss is unacceptable? A 5% dip you can shrug off — but a 25% crash would wreck your plans. Third: how long do you need the protection? A nervous month around an election, or the whole scary year ahead?

Think of it like homeowner's insurance. You do not buy fire insurance because you want a payout — you buy it so a fire cannot wipe you out. Here is the investing version: you own 100 shares of a stock at $100 each, a $10,000 position. You buy a put option with a $95 strike. That put is your insurance policy: if the stock falls below $95, the put lets you sell your shares at $95 anyway. Your position cannot be worth less than $9,500 (before the cost of the put itself, which we will cover next).

A hedging objective is simply that decision written down: "I own $10,000 of this stock, and I refuse to lose more than about 8% over the next six months." Write it before you spend a dollar. Without it, you are not hedging — you are just buying options and hoping.

Protection has a price, and it is called the premium — the amount you pay for the option. In our example, the $95 put costs $3 per share. One option contract covers 100 shares, so the premium is $300. That is the cost of your insurance.

Now the full worst case: if the stock crashes, you sell at $95 for $9,500, minus the $300 premium you paid. Your worst-case value is $9,200. Your maximum loss is $10,000 − $9,200 = $800, about 8% of your position. The floor held — exactly as planned.

Two honest truths about the cost. First: if the stock goes up, the $300 is gone — spent, like a fire-insurance premium in a year with no fire. You do not get it back. Second: protection is most expensive exactly when you want it most. In scary, volatile markets, everyone wants puts, and put prices soar. Buying puts every month forever is a slow leak on your returns. Hedge deliberately — for a reason, and for a season — not as a permanent habit.

Every protective put asks you to make two choices, and both cost money.

The strike is where your protection kicks in. A strike close to the current price — say $98 on a $100 stock — means protection starts almost immediately, so it costs more. A strike far below the price — say $90 — means you absorb the first $10 of the fall yourself, so it costs less. Choose by your objective: "I cannot stomach more than a 5% drop" points to a closer strike; "I only fear a real crash" points to a farther, cheaper one.

Duration is how long the protection lasts. Longer time costs more, because more time means more chances for something bad to happen. Match the duration to the actual worry: hedging one earnings report? Buy a put that expires after the announcement. Nervous about the next year? Buy a longer-dated put. Do not buy three years of insurance for a three-month worry — you will overpay for protection you never needed.

The rule of thumb: the strike sets where protection starts, the duration sets how long it lasts, and both choices move the price. Cheaper is not better — cheaper just means less protection.

What if the put you want feels too expensive? There is a classic answer: the collar. You keep your 100 shares, buy the protective put — and then sell a call option above the current price to help pay for it.

Selling a call means you give someone else the right to buy your shares at the call's strike. Say you sell a call with a $110 strike and collect $300 for it. That $300 exactly offsets the $300 you paid for the $95 put. Your net cost is $0 — traders call this a zero-cost collar.

The trade you made: your floor is $9,500 (the put protects you below $95), and your cap is $11,000 (if the stock rockets past $110, your shares get called away at $110 — you keep the gains up to there, but not beyond). Free protection, in exchange for giving up the moonshot.

Collars fit a specific mindset: "I want to hold this stock, I do not want to ride it down, and I am fine missing the rocket." If you believe the stock could double, a collar is the wrong tool — that sold call will haunt you. Match the strategy to the objective, always.

Sometimes you cannot buy a put on exactly what you own. Maybe your stock has no options traded on it, or the options are too thin and pricey. So you hedge with something similar instead — and that mismatch has a name: basis risk.

Here is how it bites. You own $50,000 of small-company stocks. No good puts exist on them, so you buy puts on the S&P 500 index instead. Then small caps fall 10% — you lose $5,000. But the S&P 500 only falls 4%, so your puts pay out as if the drop were 4%. Your hedge covered less than half your actual loss. The hedge and the holding moved differently, and the gap landed on you.

The rule: the best hedge matches exactly what you own — puts on your stock, not its cousin. Every step away (an index instead of your stock, a similar sector instead of your company) adds basis risk. Before you hedge, ask one question: "When my thing falls, does my hedge actually fall with it?" If the answer is "sort of," you are paying for an umbrella that only covers half your head.

OD-108 "Exercise and Assignment" shows what happens when options are actually used — who ends up with the stock, and what it means for you.