If you don’t understand options, you’re missing one of the most powerful tools for portfolio hedging.

Since market corrections and bear markets occur irregularly but repeatedly, today we’ll take a look at how you can protect your positions from fully participating in major market downturns.

If you’re a pure stock investor and unfamiliar with options or futures contracts, then you lack an effective tool for hedging — that is, protecting your portfolio or individual positions.

Don’t believe in hedging? Or do you tell yourself that buy-and-hold will eventually lead to gains?

That’s certainly one approach — but it’s not a suitable strategy if you’re not investing with a very long-term horizon, or if you’re speculating, investing in growth or volatile stocks, early-stage tech, shorting, or trading on margin.

In all of these cases, risk protection is a necessary part of trading.

Let’s try to describe a typical trader or investor.

• They buy stocks — we’ll leave aside their method of selection for now — but since everyone aims to make a profit, their portfolio will likely be a mix of conservative or defensive names, along with some more volatile or speculative positions. And make no mistake — everyone will have positions that eventually fall into loss territory, or even become complete write-offs.

• A cautious trader will at least place a stop-loss on riskier positions — a predetermined price at which they want to stop the decline and cut mounting losses. Those who rely on a long-term horizon, or who are mentally prepared to write off entire positions, may choose not to use any stop-loss at all.

  
  

This is how most traders operate: when opening a position, they either don’t think about protection at all, or they simply set a stop-loss as an emergency exit in case the trade immediately moves against them.

The Risks of Stop-Loss Orders

While stop-losses are commonly used as a basic risk management tool, they come with several important drawbacks:

1. Market Noise & Volatility:

   A stop-loss can be triggered by short-term price fluctuations, even if the overall trend is still intact. You may be taken out of a position prematurely, only to watch it recover shortly after.

2. Gaps and Slippage:

   In fast-moving markets or after bad news, the price may gap below your stop-loss level, leading to execution at a much worse price than expected — this is known as slippage.

3. Emotional Re-entry:

   After being stopped out, traders often hesitate to re-enter the same position, even if it regains strength, resulting in missed opportunities.

4. False Security:

   Stop-losses may give a false sense of protection, especially during market crashes or low-liquidity events where execution cannot be guaranteed at the desired price.

OK, let’s say the position is moving in your favor — but even then, your troubles might not be over.

And we don’t have to look far for an example — take TSLA or META in 2022, when the price dropped from nearly $400 down to below $100, reaching levels last seen six years earlier. That likely hit many of you hard.

If not, then imagine it happening to a stock you’re currently holding. The price keeps falling, getting closer to your purchase price, and your open profit starts shrinking.

Meanwhile, panic-driven headlines begin to flood in, warning that the company is collapsing under endless problems — and suddenly you’re under pressure.

You start regretting not selling at the top, thinking to yourself,

“It was obvious it was overvalued.”

What are your options without using options?

Very limited.

While some solutions do exist, they typically come with structural drawbacks or low precision.

1. Reducing Exposure / Exiting the Position

   Selling part or all of the position is the most direct way to reduce risk.

   Drawbacks:

   • May trigger a taxable gain (e.g., by violating the holding period required for tax exemption)

   • You miss out on potential dividends and future growth

   • Re-entering the market is often difficult, both in terms of timing and psychology

   
   

2. Averaging Down the Purchase Price

   In case of a loss, you can buy more at lower prices, thereby reducing your average purchase price.

   Drawbacks:

   • You are increasing your overall exposure to a risky asset

   • If the decline continues, you may end up in an even deeper loss

   
   

3. Opening an Opposite Correlation (e.g., Sector Rotation)

   You can enter a market segment with a negative correlation to the declining position (e.g., growth vs. defensive sectors).

   Limitations:

   • Requires active management, fundamental insight, and can be time-consuming

   • Correlations can break down during crisis periods like a bear market, when everything tends to fall together

     
     

4. Beta Hedging via a Short Position on an Index (e.g., SPY)

   If you know the beta value of your position or portfolio, you can open a short position on SPY in a corresponding amount.

   Advantages: cílené zajištění tržního rizika

   Drawbacks:

   • Requires additional capital and a solid understanding of beta and exposure matching

   • Shorting ETFs comes with margin requirements and dividend costs

   • Not suitable for retail investors without sufficient experience

   
   

5. Inverse ETF (eg. SH, SDS, PSQ)

   They track the inverse performance of an index (–1× to –3×) on a daily basis.

   Zásadní omezení:

   • They are designed for short-term use only — holding them longer can lead to volatility decay

   • Returns can deviate significantly from the expected inverse performance of the index over time

All of the above options are not true forms of hedging.

How to Hedge Stock Positions Using Options

Using options to hedge a stock position is the most accurate, flexible, and effective way to protect capital against unwanted declines.

It allows you to define the maximum loss without needing to close the position, change allocation, or speculate on short-term price movements.

Options give you the right to close your position at a predetermined price, or alternatively, to keep the stock positionand profit from the protective option itself — or even generate additional income on both sides of the option chainto offset losses from a drop in the underlying asset’s price.

And a protective option can even be structured at zero cost.

Let’s take a look at three approaches to option-based hedging:

1. Protective Put (Put Option as Insurance)

You buy a put option on the stock you want to protect from a price drop.

A put option gives you the right to sell the stock at a predetermined price (the strike price).

Effect:

• If the stock falls below the strike price, the put option gains value, effectively locking in the loss on the shares — you can either exercise the option and sell the stock at the strike price, or sell the option itself for a profit to offset the loss on the stock. However, if the stock continues to decline after the option is sold, the remaining shares are no longer protected.

• If the stock rises, you simply realize a loss equal to the cost of the protective option — similar to paying an insurance premium.

Example:

• We hold 100 shares of AAPL at a price of $170.

• We buy a put option with a three-month expiration, strike price $170, costing $5 per share.

• Maximum loss ≈ $500, even if the stock drops all the way to $120 — because the put option gives us the right to sell at $170, effectively locking in the protection.

2. Collar (Downside Protection with Capped Upside)

In this case, it’s a combination of buying a put option and selling a call option on the same underlying stock.

Effect:

• The put option protects against a decline in the stock’s price.

• The call option limits your upside potential if the stock rises, but the premium received from selling the call often covers the cost of the protective put → resulting in a zero-cost hedge (also known as a zero-cost collar).

Example:

• We hold 100 shares of MSFT at $300.

• We buy a put option with a strike price of $300 for $6, and sell a call option with a strike price of $320 for $5.

• This gives us downside protection and a defined upside of $20 per share, while the net cost of the hedge is just $1 per share.

Advantage:

• Minimal cost for position protection

Drawbacks:

• We lose participation in any upside beyond the strike of the call option, unless we manage the situation by rolling the call — which we won’t cover in this article.

  If the call option is exercised and the shares are sold, we can always re-enter the position, though this may result in a higher average purchase price and potentially trigger tax liabilities — factors that need to be carefully considered.

3. Index Put Options (SPX, XSP, SPY, QQQ, IWM)

Instead of hedging an individual stock, we buy a put option on a broad index that represents the core market risk of the portfolio.

When to use:

• When you want to protect a broad stock portfolio that has a high correlation with a major index

• Or when you don’t want to (or it would be inefficient) to hedge each individual position separately

Advantages:

• Effective for systematic (beta) risk, i.e., situations where diversification doesn’t help and the entire market declines

• Cheaper than buying individual protective puts

• Allows you to hedge your entire portfolio with a single transaction

Drawbacks:

• Does not protect against idiosyncratic (firm-specific) risk, such as fundamental events affecting individual stocks.

4. Adaptive Covered Call Writing

Selling a call option against a stock you hold (the covered call strategy) allows you to collect option premium, which can partially offset losses when the underlying stock declines.

If the stock price drops significantly, the investor can, with the next call option, “roll down” the strike closer to the current stock price, thereby receiving a higher premium and increasing the compensation for the decline.

Drawbacks:

• The strategy does not limit losses in an absolute sense — it only slows them down or partially offsets them

• If the market quickly reverses upward, the investor may get “called away” at a strike below market price, missing out on part of the rebound

• The strategy is not suitable during sharp sell-offs, as the premium won’t be enough to offset a fast and significant drop

Advantages:

• Additional option income lowers the effective purchase price of the stock

• The strategy works effectively in sideways or slightly declining markets

• It can serve as a form of passive protection without the cost of a traditional insurance-style hedge

This approach can be appealing for long-term investors who don’t want to exit their position but are looking for a way to offset unrealized losses without incurring hedging costs.

With careful management of strike prices and expirations, an adaptive covered call strategy can partially neutralize negative performance without the need for active portfolio management.

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As you can see, investors who lack knowledge of and access to options have only limited tools to actively defend against losses during a market downturn.

Most of these tools either involve partially exiting the market, increasing exposure at more risky levels, or using strategies with low reliability.

In contrast, options — when used correctly — allow you to:

• Precisely target downside protection

• Define the maximum potential loss

• Use capital efficiently thanks to the asymmetric risk-reward profile

Experience shows that non-option strategies may work in certain scenarios, but they tend to lose effectiveness during times of crisis. That’s why understanding options should not be seen as a bonus skill, but rather as a core competency for any investor managing larger capital or other people’s money.

A few final tips from our experience:

• Choose options with sufficient liquidity (look at volume and open interest)

• Hedge early — hedging is most effective when implied volatility is low; during crises, volatility spikes and hedging becomes much more expensive

• Match expirations to key risk events (e.g., earnings, Fed meetings, geopolitical developments)

• You don’t need to hedge your entire portfolio — focus on the most exposed or highest-risk positions