Downturn Survival Notebook, Vol. 2: When and How to Hedge with Options

In the previous episode, we covered the first—and most important—way to deal with drawdowns: cutting exposure. As a quick recap, what are the advantages of proactively trimming positions when markets start to fall?

In this episode, we move on to the second line of defense: hedging with options.

Before we dive deep into hedging strategies, it helps to identify differences between two types of drawdowns:

For a typical technical pullback, hedging is often unnecessary. One key reason is time mismatching: in a common technical pullback, when investors' technical systems trigger “hedge” signals, the sell-off may already be late-stage and close to stabilization. If you initiate hedges at that point, you risk hedging the rebound away when the market starts recovering.

In this volume, we are focused on the second type: panic-driven crashes—less frequent, but highly destructive. Over the past five years, markets have experienced this type of market crash multiple times, such as:

– March 2020: COVID shock in the U.S.

– 2022: the full-year bear market

– July–August 2024: a sharp sell-off tied to Japan’s tightening shockwaves

– March–April 2025: a global tariff escalation triggering broad risk-off

These crashes tend to arrive fast. You often don’t have time to de-risk systematicly and properly; besides, the incremental income from covered calls is rarely enough to offset a large drawdown—especially with IV expansion making option repricing violent and rapid. So, the only useful methodology is: buying protective puts.

Once the scenario is clear, the next questions are: (1) How much to hedge? And (2) What structure to use? There are two types of hedging, namely notional hedging and delta-neutral hedging.

This approach hedges the position size itself. It assumes your holdings behave broadly like the index—so hedging index volatility effectively hedges your positions.

– Tenor (expiration): match the hedge to the risk window, typically 1~2 months is enough

– Strike: near-OTM, or 3–5% OTM.

Contracts = Total stock notional / (Option price x100)

This approach take into consider the delta of options, with the goal of neutralizing the portfolio’s sensitivity to market moves—i.e., keeping the portfolio value more stable as the market fluctuates.

The option choice (tenor/strike) can be similar to notional hedging, but the sizing changes:

Contracts = Total stock notional / (Option price x Delta x 100)

ExampleAssume an investor has $100,000 in stocks and wants to hedge this week’s market risk using SPY puts expiring this week.

– Option price: $2.50

– Delta: 0.30

Contracts =100,000 / (2.50 × 100) =400

Contracts=100,000 / (2.50 × 100 × 0.30) ≈ 1,333

Notional hedging is not delta-neutral at inception. Your portfolio will still rise and fall with the market, but the amplitude is reduced. If the market rallies hard, the protective put’s delta tends to fade toward zero (especially if it goes deep OTM), so the hedge increasingly “gets out of the way” and your portfolio can still participate in upside. On the contrary, if the market falls, the put’s delta increases, and the hedge becomes progressively more protective.

In practice, this is a very intuitive profile: participate more in upside, protect more in downside. For individual investors and hedging beginners, it’s a highly usable framework.

Delta-neutral hedging aims to neutralize market sensitivity immediately at entry. But as the market moves, option delta changes—meaning your hedge ratio drifts. To maintain a truly delta-neutral profile over time, you would need frequent rebalancing, potentially daily. This methodology is more suitable for larger books and investors who can actively monitor and adjust exposures.

During sell-offs, implied volatility typically jumps, and option premiums get more expensive, which means protecting the same portfolio requires paying more premium. To reduce cost, two common “premium-offset” techniques are useful:

– Sell a lower-strike put, or

– Sell an upper-strike call

If you already bought a put, you can sell another put at a lower strike to collect premium and lower net cost.

Key caution: the put's strike must be far enough below the market. If the market falls through that short strike, the hedge payoff becomes capped—your'll lose the protection beyond that point.

You can also sell a call at a higher strike to collect premium.

Key cautions:

– The call's strike should be sufficiently out-of-the-money so a short-term rebound is less likely to challenge it.

– The call expiration should be short, and not far longer than the expected drawdown window. Otherwise, when the sell-off ends and the market transitions into an uptrend, the short call leg could become difficult to manage.

Overall, premium-offset legs should be used with a “better-than-nothing” mindset: collect what you reasonably can, but don’t expect it to fully cover the long put price.

A common mistake among newer investors is over-hedging—adding hedges at the sign of market noise. In practice, frequent hedging is one of the reasons many investors fail to let profits run.

This is why statistics can help build discipline. For example, you can study how often the S&P 500 experiences peak-to-trough declines of 3%, 5%, 10%, 15%, and 20% within a year. These distributions can help answer whether to hedge, and at what drawdown should you consider scaling the hedges down.

Example: if historical analysis shows that 15%+ drawdowns occurred 6 times in the past 10 years (less than once per year on average), then after a year has already experienced a 15%+ episode, the probability of another similar-magnitude event within the same year may be lower. After such a drawdown, if the market sells off again, you might start evaluating whether to gradually take hedge profits once the index reaches roughly 8–10% off highs.

Meanwhile, for index pullbacks in the 3–5% range, hedging is often unnecessary. De-risking, avoiding full exposure, and maintaining enough cash for buying-the-dip may be sufficient.