Today I would like to explain to everyone how I live by my creed “Always hedged, Always prepared”. Specifically, I’m going to touch on the portion of always being hedged. A lot of the terminology I use in this post might not be familiar to you if you are a beginner, so I strongly recommend reading my free eBook if you are just starting out!

What is a hedge?

A hedge is just another word for protection; protection from your trade going the other way. There are a ton of ways to hedge a specific position and your portfolio; I am only going to cover 3 really basic hedges that you can start using tomorrow.

One type of hedge is to hedge on opposite price movement. What this means is that you will take on 2 different positions where each position price moves inversely to the other. If position A moves up, position B moves down. I call this “inverse hedging” which is just a name I came up with for this particular hedge. There is a practice called “Shorting against the box” where you will go long a certain amount of stock and simultaneously go short the same amount of stock. This might be considered a hedge but obviously; there isn’t much of a point. You won’t make or lose any money. The point of hedging is simply to protect your position or portfolio in case it goes in the other direction. In the case of inverse hedging you might go long $1,000 on a stock and take on about $300 in your inverse hedge. That way you are protected in case the trade goes against you.

Although I have used inverse hedging with success, I don’t use it that often just because I think there is a much better way of doing it. I did want to explain it just to give you an insight into one of the many ways you can hedge your portfolio.

The type of hedging that I use I call “Position hedging” where I use a derivative instrument on the same stock to protect the position. To me it is imperative that I always have some sort of downside protection in case things go bad. You will always have a lower dollar amount invested in your hedge when compared to the actual position you are trying to protect. If the position goes in your favor you will most likely lose the dollar amount invested in your hedge, or some portion of it. If your position goes against you; you won’t lose as much money as you would have without one. That, in the final analysis, is the art of the hedge! I like to use derivatives to hedge my positions, and more specifically I like to use options. The reason being; they provide far more leverage than stocks do, so you are able to use a smaller dollar amount to cover a much larger investment. Enough of that, let’s get to the actual strategies

1) Protective Puts

A protective put is very simple to create as it involves 2 steps.

•Long 100 stock

•Long 1 put contract

It doesn’t always have to be 1 put contract per 100 shares. I can’t tell you exactly how many contracts and at what strike price you need to acquire them, as it depends on how much protection you are looking to place on your position. This is something that you need to test in your paper trading. This is a common strategy that I use and it definitely has helped me especially on highly volatile stocks. The risk profile of the position is shown below.

2) Covered Calls

I go over covered calls extensively in my free eBook which you should have received as a member. I’m just going to cover the basics here. Setting up a covered call is also a 2 step process

•Long 100 stock

•Short 1 call contract

In the case of covered calls, you can only write 1 call contract per 100 stock for it to be considered a true covered called. If you were to write more than this it would be considered an uncovered contract or “naked call”. Naked call writing is a very advanced strategy which I would not recommend using, and your broker most likely will not allow you to. The risk profile of the position is shown below.

What you will notice from this risk profile is that the upside is limited to the strike price of your call. Any price movement above the call and you will get assigned on the contract. Your breakeven price is lower than what it would have been if you just went long 100 stock.

Collar Spread

The last hedging strategy that I would like to show you is a collar spread. This strategy is used in many conservative portfolios. Setting up a collar is a 3 step process

•Long 100 stock

•Short 1 call contract

•Long 1 put contract

If you will notice; this position is a combination of the two above. The stock is your base which is what you are trying to hedge. You write one call to earn an options premium on the position and buy one put to have further protection to the downside. The risk profile is shown below.

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Thank you for reading, and I hope you enjoyed this lesson!