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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