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How To Hedge With Options Against a Stock Market Crash

October 6, 2020 by Daniels Trading| Tips & Strategies

If nothing else, the 2020 coronavirus (COVID-19) pandemic reminded us of the importance of risk management. From late February through the end of April, unprecedented levels of volatility swept the world’s equity, commodity, and currency markets. Traders familiar with the principle of diversification and how to hedge with options protected their wealth and may have prospered.

Let’s take a look at how you can use equity index options on futures to guard against losses due to a stock market crash.

Equities Options on Futures 101: Contracts

If you have experience trading stocks, then you are aware of the vast number of alternatives in the market. Individual corporate shares, stock options, mutual funds, and ETFs (leveraged and inverse) are several of the most popular. For a broad view of American equities market performance, investors key a close eye on these four prominent indices:

  • Dow Jones Industrial Average
  • Standard & Poor’s 500
  • NASDAQ Composite
  • Russell 2000

On the Chicago Mercantile Exchange (CME), there are a host of contracts designed to mirror these four American equities indices. For stock traders learning how to hedge with options, it’s important to become familiar with the CME’s lineup of E-mini equities index products:

  • E-mini DOW (YM)
  • E-mini S&P 500 (ES)
  • E-mini NASDAQ 100 (NQ)
  • E-mini Russell 2000 (RT)

These four futures contracts provide traders the ability to engage American small-, medium-, and large-cap equities. Each contract also acts as the basis for a corresponding options chain. Known as futures options or options on futures, these contracts function much like traditional stock options, featuring countless strategic applications.

Using Options on Futures to Hedge Stock Market Risk

During the spring 2020 stock market crash, the leading American indices took a beating as participants attempted to price in COVID-19. This phenomenon was evidenced by the E-mini S&P 500 repeatedly hitting its initial 7 percent circuit breaker in March.

Diversification, or spreading holdings out across various asset classes and products, played a key role in weathering the COVID-19 financial storm. Astute investors knew how to hedge with options, and they diversified their portfolios accordingly. Here are two of the most popular options-based strategies for managing a market crash.
Gain a competitive advantage in today’s markets. Check out our guide The Ultimate Guide to Hedging: How to Reduce Risk >>

Buying In-The-Money (ITM) Puts

Perhaps the most basic way of hedging against a stock market crash is to buy in-the-money (ITM) puts on equities index futures. Buying a put gives the holder the right, but not the obligation, to sell a futures contract at a specific price on some forthcoming date in time. If you’re interested in how to hedge with options against a market crash, it’s worthwhile to learn all about buying ITM puts.

By buying an ITM put option, you can sell a futures contract at or near the current market price by or on some forthcoming date in time. If the market were to crash after you buy an ITM put, profits are theoretically unlimited. Further, the only assumed risk is the up-front premium you paid for the put option itself.

Assume that Erin the S&P 500 investor became leery of the market amid the late-February 2020 onslaught of COVID-19. Erin could have protected stock, ETF, or mutual fund holdings by simply buying an ITM E-mini S&P 500 put option. If she did this, gains generated by the put option in March 2020 could have largely mitigated losses taken in the stock market.

Straddles

A straddle is an options strategy in which the trader simultaneously buys both put and call options with identical strike prices and expiration dates. In doing so, the trader secures exposure to the long and short side of the market, profiting from any directional bearish or bullish move.

During the run-up to the 2020 U.S. presidential election, let’s say that Erin the investor is uneasy about growing political uncertainty. On Oct. 1, 2020, Erin decides to put a straddle on the E-mini NASDAQ to hedge exposure to the tech and growth sectors. Erin simultaneously buys March 2021 E-mini NASDAQ calls and puts with a strike price of 11,500.25.

By executing the straddle, Erin has hedged exposure to the short side of the NASDAQ and added to the existing upside potential. If the market crashes, gains from the put will largely offset losses realized by NASDAQ holdings, and if the market rallies, gains from the call will be added to those of any NASDAQ holdings. Should the market remain flat, Erin will only absorb the cost of the call and put option premiums.

Hedgucation 101: How to Hedge with Options

For more information on the world of risk management, check out Daniels Trading’s e-book The Ultimate Guide To Hedging. In it, you’ll find vital information on futures, options, market analysis, and risk. The Ultimate Guide To Hedging is a great starting point for anyone interested in learning how to hedge with options and futures.

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Filed Under: Tips & Strategies

About Daniels Trading

Daniels Trading is division of StoneX Financial Inc. located in the heart of Chicago’s financial district. Established by renowned commodity trader Andy Daniels in 1995, Daniels Trading was built on a culture of trust committed to a mission of Independence, Objectivity and Reliability.

Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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Risk Disclosure

The StoneX Group Inc. group of companies provides financial services worldwide through its subsidiaries, including physical commodities, securities, exchange-traded and over-the-counter derivatives, risk management, global payments and foreign exchange products in accordance with applicable law in the jurisdictions where services are provided. References to over-the-counter (“OTC”) products or swaps are made on behalf of StoneX Markets LLC (“SXM”), a member of the National Futures Association (“NFA”) and provisionally registered with the U.S. Commodity Futures Trading Commission (“CFTC”) as a swap dealer. SXM’s products are designed only for individuals or firms who qualify under CFTC rules as an ‘Eligible Contract Participant’ (“ECP”) and who have been accepted as customers of SXM. StoneX Financial Inc. (“SFI”) is a member of FINRA/NFA/SIPC and registered with the MSRB. SFI does business as Daniels Trading/Top Third/Futures Online. SFI is registered with the U.S. Securities and Exchange Commission (“SEC”) as a Broker-Dealer and with the CFTC as a Futures Commission Merchant and Commodity Trading Adviser. References to securities trading are made on behalf of the BD Division of SFI and are intended only for an audience of institutional clients as defined by FINRA Rule 4512(c). References to exchange-traded futures and options are made on behalf of the FCM Division of SFI.

Trading swaps and over-the-counter derivatives, exchange-traded derivatives and options and securities involves substantial risk and is not suitable for all investors. The information herein is not a recommendation to trade nor investment research or an offer to buy or sell any derivative or security. It does not take into account your particular investment objectives, financial situation or needs and does not create a binding obligation on any of the StoneX group of companies to enter into any transaction with you. You are advised to perform an independent investigation of any transaction to determine whether any transaction is suitable for you. No part of this material may be copied, photocopied or duplicated in any form by any means or redistributed without the prior written consent of StoneX Group Inc.

© 2023 StoneX Group Inc. All Rights Reserved

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