Hedging Your Portfolio with Index Options
Jim Graham

Institutions and mutual funds are the biggest customers for index options. To manage large diversified stock portfolios, it is easier to purchase puts on an index or sector rather than doing hundreds of trades on each individual stock. When analyzing how to hedge their risk, they must balance the cost of the strategy against their opinion of the market.
 
The objective of the index option purchase is to limit or insure against portfolio losses. But index puts are not cheap. So why are managers willing to risk underperforming the market by 3% or so during a 90-day period (approximately a 13.2% annual rate)?
 
Some try to keep a little protection on no matter what the current market conditions are like.  But it is only natural that they are more willing to take that risk if they have a bearish view. They hope to beat the market by profiting from the index puts.
 
The technique of hedging a portfolio is straightforward. The first step is to find the index with the composition that most closely resembles your own portfolio. You then purchase out-of-the-money protective puts.
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