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"Using Protective Put As Hedge For ETFs?"

Question By Neil Platt

"Using Protective Put As Hedge For ETFs?"

I am just learning about options. I would like to increase my investment in stocks at this time but want to protect against further market declines. Can you use protective puts as a hedge with Exchange Traded Funds? Thanks

Asked on 15 April 2009

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Answered by Mr. OppiE

Hi Neil,

Welcome to!

I am glad that you are comtemplating using options the way it was meant to be used even as a beginner to options trading. Stock options were designed initially as hedging tools, not speculative tools and protective puts are the main reason behind the creation of put options.

Exchange Traded Funds (ETFs) are funds that are traded over an exchange just like a stock and is based on some index or underlying asset. The most popular ETFs are the QQQQ, DIA and SPY which tracks the Nasdaq 100, DJ-30 and S&P500. Buying ETFs is also great way to diversify your money into multiple stocks with very little money. Most popular ETFs, like the ones mentioned, are optionable. This means that they come with options and as long as they have put options available, you can perform the protective put options trading strategy.

For instance, the QQQQ is trading at $32.40 today. You think the economy might be recovering and you wish to hold QQQQ for the long term but wishes to hedge against downside risk using protective put. What you could do is to buy QQQQ at $32.40 and buy to open a corresponding amount of further month out of the money put option such as the May32Put, which will hedge against the QQQQ falling below $32. Of course, if you wish to hold the QQQQ for a much longer term, you should purchase longer term put options so that you save on commissions and premium (yes, buying near term put options over and over again, month after month, adds up to much more extrinsic value than the outright purchase of longer term put options).

In conclusion, hedging Exchange Traded Funds (ETFs) with the protective put options trading strategy is entirely feasible as long as the ETF is optionable.

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