Using Options to Protect Your Portfolio

Using Options to Protect Your Portfolio

Len Yates, President, OptionVue Systems International

From the lows of the 2008 crash, the U.S. markets have rallied and fallen and the markets now seem to be pushing down to retest their lows for the year. It may be that the worst is nearly over and the markets will begin to turn up.

Even if the selling continues, the good news is that hedging with options is a terrific way to fight back. The simplest ways to hedge a stock portfolio are buying puts or selling calls. I prefer buying puts, because if the next selling wave carries the market deep, I want my puts working harder for me the farther the selloff goes. This happens automatically because as the puts get driven into the money, their delta naturally increases. In contrast, short calls would be going out of the money at that time, their delta dropping, and their protection growing weaker.

You can either buy puts on each of your individual stock holdings, or buy an appropriate number of index puts. I prefer the later because it's so much simpler to get in and out of my puts at various stages of the bear market. Ideally, you should pick an index that is indicative of your portfolio, and has a liquid options market. For instance, the SPY is best for a diversified portfolio of larger cap stocks. Those who own mostly small cap stocks might consider using the IWM, while the QQQQ would match up well with a portfolio made up mostly of tech stocks. All three of these ETFs are heavily traded and have very liquid options markets.

To figure an appropriate number of index options to buy, you need to calculate the "portfolio delta" of your portfolio in term of the ETF that is the best match. The OptionVue 6 software tells you which index is the best match and calculates this portfolio delta automatically.

You can also do a rough calculation for portfolio delta on your own. First, start with the dollar value of your stock portfolio, divide by the price of the index, and then apply a "fudge factor" for your beta. For example, if you think your stocks are 15% more volatile than the S&P 500 (SPY), multiply by 1.15. The result is the number of equivalent deltas of the index or ETF your portfolio represents.

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For example, let's say you have $150,000 worth of high tech stocks. Divide by the price of the SPY (currently $90) and you get 1,667. Multiply by your beta fudge factor of 1.15, and you have ~1,917 SPY deltas. In other words, it's as though you have approximately 1,917 shares of SPY.

To hedge this fully, you would need to buy enough puts (and/or sell enough calls) to bring your net delta down to zero. Using at-the-money (ATM) puts – which typically have a delta around 50 each – this would require 38.3 puts (1,917 divided by 50) which I would round down to 38.

To partially hedge, you could buy fewer than 38 ATM put contracts. To over-hedge (something I like to do when I feel sure the market is going down), you could buy more than 38 put contracts.

Since options are so expensive these days, it is important to buy and sell them in rhythm with the market. To hedge this $150,000 portfolio you could currently purchase the ATM June 90 Quarterly SPY puts (expiring June 30, 2009 with 57 days of life remaining) at the current ask price of $4.75. That means it would cost you $18,050 to fully insure that $150,000 portfolio, or almost 12% of its value.

That is much more expensive than the 3% most money managers use as a rule of thumb for the cost of hedging a portfolio. This is indicative of the high premiums in equity indices these days.

As for getting a feel for the rhythm of the market, I really don't know any way other than through experience. But I will say that the market is way more predictable during a selloff. For example, following a sharp break and a 50% rebound, it's a pretty safe bet to go short. If you can catch the market in a climatic selloff day that's a beautiful opportunity to sell the puts and let your stocks go back up unhedged – maybe even buy a few calls for a 24-hour play – as there most certainly will be a smart rebound. When the rebound is finished, you can think about shopping for puts again. And so it goes.

I would not just buy puts and let them sit. This might work for some people, but I prefer to time the market. I browse through a lot of stock charts every day. If I see a lot of stocks ready for another "break", then I figure the market is about to "break". That's when I buy puts. I sell my puts in 3 – 6 days when it looks like the current selloff has run its course.

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