Hedging Coronavirus Market Risk With Stock Options

  • Option contracts can help investors can hedge downside risk when the potential for market loss is elevated.

  • The expense associated with using options to establish a hedge can also be a drag on portfolio performance if the market subsequently heads higher.

  • Whether option-based portfolio insurance makes sense for you depends on your investment objectives and market conditions.

Energy cannot be created or destroyed, it can only be changed from one form to another”  — Albert Einstein

For the past several months, a world war has been wedged against the COVID-19 virus. Encouraging signs of progress on the medical front of this war has led to a large number of predictions regarding how the battle will play out on the economic front.

McKinsey & Company recently published an illustration of various possibilities for the direction the economic recovery might take.

While these types of illustrations are helpful, anyone who claims to know for sure which course the U.S economy will take in the weeks and months ahead is either lying or kidding themselves.

In an unstable economic environment, option contracts can help investors can lessen downside risk.  A “stock option” is a right to buy or sell stock (or ETF shares) at a pre-determined price on or before the “expiration date” specified in the option contract.  Listed options are sold on regulated exchanges, such as the Chicago Board Options Exchange (the “CBOE”), in much the same way that stock is traded on the New York Stock Exchange. 

There are two types of stock options contracts.  “Puts” give the person who purchases the contract (the “holder”) the right to sell the stock at a specified “strike” price to the person who sells the call option (the “writer”) on or before the expiration date. “Calls” give the holder the right to buy the stock from the writer at the strike price on or before the expiration date. 

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