To hedge a stock portfolio against market risk with options, the most direct method is to buy index put options (for example on SPY) so that losses in the portfolio are partly offset by gains on the puts. Four cheaper variations trade some protection or upside for a lower cost: a collar (buy a put, sell a call), a put spread (buy a put, sell a lower-strike put), a fence (a put spread plus a sold call), and a covered call, which only cushions small declines. The right choice depends on how much protection you need, how much upside you will give up, and what the hedge costs.
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Options hedges cost less capital than selling the portfolio because each contract controls 100 shares. Deep in-the-money options cost more because they already have intrinsic value; far out-of-the-money options are cheap because they are unlikely to finish with intrinsic value. The objective is to reduce the impact of a market decline, using one option or a combination of two or three.
Five option strategies to hedge a stock portfolio
1. Long Put Position
A long-put position is the simplest but the most expensive option to hedge portfolio downside due to market risk. Usually, an investor will purchase an option with a 5 or 10% strike price below the current market price for a time duration for which excessive market volatility is expected. These options will be cheaper but will not protect the portfolio against the first 5 or 10% that the index declines. The longer the put option duration, the higher premium the investor must pay.
2. Collar
A collar buys a put option and sells a call option with the same expiration. The call premium pays for part or all of the put, and in exchange the portfolio's upside is capped at the call strike. If the index rises above the call strike, the short call loses money, offset by gains in the portfolio. A collar limits losses below the put strike but is not a perfect hedge: losses between the current price and the put strike are not protected.
3. Put Spread
A put spread buys a put and sells a lower-strike put with the same expiration, which lowers the cost of protection against a moderate decline. For example, a portfolio manager can buy a put with a strike at 95% of the current price and sell a put at 85%. The sold put offsets part of the cost of the bought put. The hedge only protects between those two levels: if the price falls below the lower strike, further losses are not covered.
4. Fence
A fence is basically a combination of a collar strategy and a put spread strategy. In this strategy, an investor goes long on a put with a strike price below the current market level and sells both a put option with a lower strike price and a call option with a much higher strike price. The result is a low-cost structure that protects the portfolio from downside and at the same time allows for a limited upside.
5. Covered Call
In a covered call strategy, an investor sells out of the money call options against a long equity position. It doesn’t reduce downside risk, but the premium earned does offset potential losses. This strategy is more effective on individual stocks and hence more popular for an undiversified portfolio. Losses on the option position offset a certain amount of gains on the equity position if the stock price climbs over the strike price.
Selecting The Suitable Hedge Strategy For Your Portfolio –
There is no sure-shot way to choose the best available options when hedging stocks. However, the user can consider the pros and cons of the available strategies and make an informed choice. Several factors need to be considered while evaluating alternatives. The first decision will be to decide how much the portfolio needs to be hedged. If the portfolio is well-diversified, the entire portfolio is already hedged to an extent. However, maintaining a beta value of 1 at all times is not possible. In that case, there would be a requirement to hedge it.
The more concentrated your wealth is in equities, the larger the hedge you may want.
After deciding on the type of hedge, price the candidate strategies before choosing. With MarketXLS, an Excel add-in, you can pull S&P 500 index and SPY option chains into a spreadsheet with =QM_GetOptionChain("SPY") and compare the cost and protection of each structure; MarketXLS also has templates for each strategy. Options data is end-of-day on the Standard plan and real-time on the Advanced and Business plans. Place the trades with your broker.
See the MarketXLS templates library for the strategy templates. This article is educational and not investment advice.
