How Can OTM Options Be Used for Hedging a Portfolio?

While less common than using ITM or ATM options, OTM options can be a cost-effective way to hedge a portfolio against a sharp, adverse price movement. For example, an investor holding a large stock portfolio could buy OTM put options.

These puts are cheap and will only pay off if the market experiences a significant downturn (a "black swan" event). While they won't protect against small losses, they provide a form of catastrophic insurance, offering a large payout that can offset major portfolio declines for a relatively small initial cost.