Hedging with Options
Protect your portfolio from catastrophic losses using options-based hedging strategies
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Hedging with Options
You can be the best premium seller in the world and one Black Monday wipes out two years of gains. Hedging is not about making money — it is about surviving the event that would otherwise end your trading career. Think of it as insurance: it costs money every month but it keeps you in business.
Why Hedge?
A premium-selling portfolio is structurally short volatility. You profit when markets are calm and lose when markets crash. The problem is that market crashes are rare but devastating.
Without hedges: A 10% market drop in a week might cause a 25% to 40% portfolio drawdown for a fully invested premium seller. Recovering from a 35% drawdown requires a 54% gain.
With hedges: That same 10% drop might only cause a 10% to 15% drawdown. The hedges offset the worst of the losses. You recover faster and you do not panic-close positions at the bottom.
Hedge 1: Long SPY Puts (Tail Risk Protection)
The simplest hedge: buy far out-of-the-money SPY puts.
Setup: Buy the SPY put that is 10% to 15% below the current price, 60 to 90 days to expiration.
Example: SPY at $450. Buy the $390 put (13% OTM), 90 DTE, for $2.50 ($250 per contract).
If SPY drops to $400 (11% decline), this put is worth roughly $8.00 to $12.00. You turned $250 into $800 to $1,200. If SPY stays flat, you lose the $250.
Cost: Budget 1% to 3% of your account value per year on tail hedges. On $100,000, that is $1,000 to $3,000 per year — about $100 to $250 per month.
How many contracts? Calculate your portfolio's beta-weighted delta loss in a 10% crash. If that loss would be $15,000, buy enough puts to offset $10,000 to $12,000 of it. Usually 3 to 5 far OTM puts on a $100,000 account.
Hedge 2: VIX Calls (Volatility Spike Protection)
VIX calls profit when fear spikes. Since your premium-selling portfolio loses money when VIX spikes, VIX calls are a natural offset.
Setup: Buy VIX calls at the 20 to 25 strike, 30 to 60 DTE.
Example: VIX at 15. Buy the $20 VIX call for $1.50 ($150 per contract).
When VIX spikes to 35 (which happens during market panics), this call is worth $15.00 or more. That is a 10x return during exactly the scenario where your portfolio is bleeding.
Caution: VIX options are priced off VIX futures, not the spot VIX. When spot VIX is at 15, the 30-day VIX future might be at 18. VIX calls are often more expensive than they appear. Also, VIX options expire on Wednesdays, not Fridays.
Budget: 0.5% to 1.5% of account value per year on VIX calls.
Hedge 3: Put Ratio Spreads (Reduced Cost)
If straight puts are too expensive, use a ratio spread to reduce the cost.
Setup: Buy 1 SPY put at-the-money, sell 2 SPY puts further out-of-the-money.
Example: SPY at $450.
- Buy 1x $445 put for $8.00
- Sell 2x $425 put for $3.00 each ($6.00 total)
- Net debit: $2.00 ($200)
If SPY drops to $430, the $445 put is worth $15. The $425 puts are worth $2.50 each ($5.00 total). Your P&L: $15 - $5 - $2 = +$8.00 ($800).
If SPY drops to $425, the $445 put is worth $20. The $425 puts are at-the-money ($0 intrinsic). Your P&L: $20 - $0 - $2 = +$18.00 ($1,800).
But if SPY drops below $405 ($425 - $20), the short puts start losing money faster than the long put gains. This hedge has a floor — it does not protect against a total market meltdown below a certain level. It is cheaper but has limitations.
Hedge 4: Collar on Core Positions
If you own stock (through wheel trades or long-term holdings), a collar protects the downside while capping the upside.
Example: You own 100 AAPL shares at $190.
- Buy the $175 put for $3.00 (protection below $175)
- Sell the $205 call for $3.00 (finances the put)
- Net cost: $0 (zero-cost collar)
AAPL cannot hurt you below $175 and you participate in upside to $205. In a market crash, AAPL could drop to $140 and your loss stops at $175. The call premium paid for the put premium.
How Much to Spend on Hedging
The 1-3% rule: Spend 1% to 3% of your annual premium income on hedges.
If your premium-selling portfolio generates $15,000 per year in income, budget $150 to $450 per year on hedges. That sounds small, but far OTM puts and VIX calls are cheap — and they only need to work during the rare events that matter.
The portfolio impact: Yes, hedges reduce your net return. A portfolio generating 18% gross return might net 15% after hedge costs. But that 15% comes with dramatically less tail risk. Compounding 15% annually with small drawdowns beats compounding 18% with occasional 40% drawdowns.
When to Refresh Hedges
Rolling tail puts: When your SPY puts get to 30 DTE, roll them to the next 90-day cycle. If the market has moved up, adjust the strike higher. If it has dropped, your puts are already partially in play.
VIX calls: Roll every 30 to 45 days. VIX calls decay rapidly due to the contango in VIX futures. Buy the next month when the current month has 15 to 20 DTE.
After a spike: If VIX spikes from 15 to 30 and your hedges paid off, do not immediately re-hedge at the elevated level. Wait for VIX to settle back to 20 to 22 and then re-establish hedges at a more reasonable cost.
The Hedging Mindset
Most months, your hedges will lose money. That is the point. You are paying a small amount to protect against a large loss. When traders see their hedges expire worthless month after month, they stop hedging. Then the crash comes.
Treat hedge costs like rent. You pay it every month. You do not resent it because it keeps a roof over your head. Hedges keep a floor under your portfolio.
Next: diving into volatility trading — making volatility itself your edge.