price where the index ended up and the
put strike. This cash becomes part of the
asset value of your portfolio. It may not
correlate perfectly (i.e., dollar-for-dollar
cash gained per dollar lost in your stocks),
but it can certainly help make a stock loss
HOW MUCH DO YOU NEED?
There’s no hard-and-fast rule, but you
might expect to spend between 3% and
5% of your portfolio value on each hedge.
Don’t let that scare you. There are ways to
potentially bring the cost down so you don’t
empty your wallet.
When assessing the correct amount of
limited protection (or hedge), first find an
index that closely
relates with) the
stock mix in your
portfolio. If your
basket is balanced
across sectors, con-
sider using the S&P
500 Index (SPX),
as shown in Figure
1. If it’s weighted in
(NDX) might be a better fit, and so on.
Once you’ve snagged the best correlating index, calculate how many puts you
need to buy. Suppose your hypothetical
stock portfolio worth $250,000 contains a
dozen or so different large-cap stocks that
can be found in the S&P 100 Index (OEX).
STOCK “PRO TECTION” 101
You probably know that puts are often
used by option traders to speculate if they
believe the price of a stock or the market
in general is going down, or to help protect
a position in case the market or stock goes
down. The latter—trying to protect a single
stock position—is simple. But it gets a little
more complicated when you size up an
index put to hedge a basket of stocks.
Let’s back up a minute. Put hedges are
simple in principle. If you insure your
home, your car, or your precious Persian
kitty, you probably own insurance policies that, in theory, work similarly to
puts. You’re well aware that if the sky falls
and your car is a pancake, the car may be
worthless, but that auto policy you spent
$1,000 on suddenly becomes worth a
whole lot more. In fact, you get to “put,” or
transfer, the cost of the car replacement to
your insurance company.
Puts give traders the right to sell their
underlying stock at the strike price for a
limited time (until the option expires). If
you own index puts, there’s no underlying
stock deliverable. They are “cash settled.”
So, at the expiration of your long index put,
if your puts are in the money (put strike is
higher than index-settlement price) you’d
receive the cash difference between the
At this point, using OEX put options, you
might be able to create a hedge using the
CALCULATE THE INDEX’S CASH VALUE.
The cash value of OEX is an average of the
100 stocks in the index. It’s calculated using
a multiplier of 100 (which happens to be
the multiplier on most indices). On May 1,
2019, the index closed at 1297. Therefore,
the cash value of OEX was $129,700.
DETERMINE THE NUMBER
OF PUTS YOU NEED TO BUY.
Simply divide your hypothetical portfolio
value by the cash value of the hedging index
to get the number of offset deltas you need
to be fully hedged: $250,000 ÷ $129,700 =
1.93 (or 193 deltas).
Here, delta measures the degree for
which a put might offset a dollar loss in
the underlying. (See page 26 in this issue
for more on delta hedges.) Typically,
at-the-money (ATM) put options have a delta
near -50. So to put on an ATM hedge for
this position, you’d likely need at least four
ATM OEX puts to hedge your hypothetical
portfolio, which would put you near -200
deltas. Close enough.
COST OF YOUR HEDGE.
Next, decide how far out in time you
want protection, say, a minimum of three
months, then choose where you’d like your
greatest amount of protection to be—
perhaps near the index price.
On May 1, the 1300-strike option expiring
in 106 days was $40. The cost of the transaction would be calculated as the number
of puts times the put price times 100: 4 x 40
x 100 = $16,000.*
ou’ve been sleeping under a rock if you’ve never heard the
adage, “Don’t put all your eggs in one basket”—sage advice for the
buy-and-hold investor, but Greek to most traders. (What’s a basket?
Are you selling me egg futures?) If you are an option trader and
also plan on owning a diversified basket of stocks for the long haul,
this might be a good time to stretch your knowledge and learn how to
put on a portfolio hedge using index options.
WAYS to find
an index that
is to pull up the
Monitor tab in