Options -- The Striking Price: A Hedging Strategy for Nervous Investors -- Barron's

Dow Jones
01 Mar

By Steven M. Sears

Stocks have risen for so long, with so few interruptions, that a little market weakness creates lingering investor unease, much like a bad virus that won't go away.

Even though recent stock declines have been orderly, and even though they occurred after the S&P 500 index set an all-time high, the market is increasingly agitated about President Donald Trump's tariffs and the high valuations of top technology stocks.

The Magnificent Seven -- Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla -- have long led the market higher. Their businesses have been relatively immune from economic cycles, but the market mob's fears are taking over, leading some investors to begin hedging their portfolios and doubting an investment playbook that has produced strong results for many years.

Until Nvidia reported earnings on Wednesday, investor sentiment was wobbly on tech stocks. Its results were robust, but slight profit-margin weakness and some concerns about its ability to keep growing at such a fast rate have chilled investors.

Nvidia, for now, appears to have a slightly tarnished halo. The company must demonstrate that it hasn't lost its mojo. It has become a show-me, don't tell-me stock. The ripples may reduce the fervor that investors have for major tech stocks.

Investors concerned that the chilled reaction to Nvidia's otherwise strong earnings report is a glimpse of the future can hedge their portfolio with put options on the Technology Select Sector SPDR exchange-traded fund (ticker: XLK). With the ETF at $222.54, they could buy the March $220 put and sell the March $205 put for about $3.05. If the ETF is at $205 at expiration, the spread is worth a maximum profit of $11.95.

During the past 52 weeks, the tech-sector proxy has ranged from $190.75 to $243.14.

We suggested a somewhat more complex hedge on the S&P 500 in January, but the spread strategy outlined here is simpler and can be applied to many stocks and sectors, including the broad market.

Puts, which give holders the right to sell a stock at a set price and time, are often more expensive than bullish calls. That's because investors buy puts to hedge stocks, so put prices tend to exceed the asset's rational value.

Spread strategies -- that is, buying one option and selling another with a different strike price but the same expiration -- are often more attractive than buying a single put because spreads cost less: The sale of one put offsets the cost of buying another.

Another spread-strategy benefit is that it helps investors control their own greed. Correctly wagering on a stock's demise is a heady experience. When the stock falls as expected, the put value often surges -- and so does investor greed.

In fact, rather than taking profits on the plump put, many investors convince themselves that they will make even more money if the stock keeps declining. They hold on to the put and often fail to take profits before the stock price retraces its losses. A spread has a predetermined maximum profit, which makes it easier to manage.

We share the tech-sector hedge in deference to investors who are interested in reducing the risk of owning equities at elevated levels. The risk to hedging, of course, is that the underlying stocks strengthen, rather than weaken. Should that happen, the money spent hedging will be lost. Such is the reality of trying to pace the market's twists and turns with options.

Our preference remains using stock market weakness to buy quality stocks on declines. The U.S. economy is strong, corporate earnings are growing, and lending markets are increasingly business-friendly. Yet these facts don't fit into the prevailing market narrative. Investors who prefer to lock in gains on highflying stocks should consider a spread strategy.

Email: editors@barrons.com

 

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(END) Dow Jones Newswires

February 28, 2025 21:30 ET (02:30 GMT)

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