While options can be used to speculate on the market, these trading tools also have many other purposes, too. Hedging is one of the many uses for options, and is often employed by shareholders looking to protect their portfolios. By purchasing puts on an equity that is already held, or using index puts to hedge an entire stock portfolio, an investor can wait out a span of expected weakness or volatility in the shares, and ultimately limit his losses. In other words, hedging is to a shareholder what car insurance is to a driver.

Unlike speculating, the main purpose of hedging is not to turn a profit. In fact, in many cases, the trader actually wants the option to expire worthless. A protective put is one of the most popular hedging strategies and involves simply buying a put against an individual stock already in one's portfolio. If a short-term pullback in the shares is expected, but the long-term picture is still positive, a put may be purchased to guard against near-term losses.

Similarly, if a broad-market pullback is threatening, portfolio insurance can be acquired through the purchase of put options. For example, the S&P 500 Index (SPX) and Russell 2000 Index (RUT) are both optionable, as are other exchange-traded funds (ETF) based on broad-market indexes. These index or ETF puts will increase in value, should their corresponding broad markets retreat. Consequently, portfolio losses sustained in the stock's pullback can be offset by the gains absorbed by the purchased puts.

Let's revisit the insurance analogy. Essentially, hedging with options is a sensible way to protect a stock position or a portfolio -- but remember, nothing is free! In instances where the market or the stock does not decline, the premium for the put "insurance" is lost once the option expires, and the portfolio profits banked from the stock are reduced by the cost of the protective puts. However, for a relatively low up-front cost, the trader is able to protect his portfolio with options -- and perhaps sleep a bit better at night.