I came across this article about Mark Cuban buying put options to hedge his Netflix long position, which he believes is severely undervalued. Now, while I believe Netflix is grossly overvalued, – and yes, even after the 37% drop from its December peak -, buying puts on a volatile stock is rarely a good idea. It’s a very emotional one. And if there’s anything I’ve learned about the investing game in my short career, it’s that you have to keep your emotions out of it. Would you ever short a stock you believe is undervalued? Probably not. So, why buy put options on it?
If you believe that a stock is undervalued, then the put option on that specific stock is overvalued, because the stock is more likely to rise than fall. Meaning that the put options you buy are more likely to go to Zero than to make you money. So, buying puts on your long positions each time we see volatility in the markets will set your portfolio up for under-performance because:
- You waited for volatility to hit before buying the put options, you’re overpaying at this point
- When volatility subsides, the value of those puts will fall off a cliff, and you’ll want to sell them.
- If the stock is undervalued, then it is likely to rise, meaning the long-put will likely lose its value.
How should you hedge to maximize returns?
- Buy put options on stocks you believe are overvalued and will fall (with a catalyst) regardless of what the market does, and not on your long positions.
Hedging your portfolio with stocks you believe will fall regardless of what the market does ensures that even when volatility subsides, you will still be confident that those put options will eventually come out on top. So, while they hurt short-term performance, they enhance your portfolio’s return over the long-term.