Hedging your equity portfolio with a stock index option

QUESTION: How can you save time and money in hedging your equity portfolio?

ANSWER: Find an appropriate proxy index and hedge in one market instead of every stock you own. 

With the Dow Jones Industrial Average trading above 13,000 in late-February, up 34% from its two-year lows (9,686 on July 5, 2010), many long-term investors may be tempted to take their gains and run. Though the lackluster economy is showing some signs of strength, the recovery is by no means guaranteed, and getting out 1,000 points from the all-time highs seems prudent. More sophisticated investors may opt to lock in their current gains using puts to hedge their individual stocks, thus allowing for the possibility of more share appreciation. 

Hedging shares of stocks with puts is relatively straightforward. Because each put allows the holder of the option the right, but not the obligation, to sell the shares at a specific price (strike price), a large decline in the price of the stock is offset by an increase in the price of the put hedge. For every 100 shares of stock, one put contract is required as a clean hedge. Thus, someone wanting to hedge 100 shares of Intel (INTC) will hedge with one INTC put contract.

Investors and traders utilizing equity options to hedge and enhance their portfolio performance have been able to avoid some of the nastier blow-ups of the last decade. Certainly anyone hedging Enron, WorldCom, Bear Stearns or Lehman may have taken a hit, but not the total disaster of unhedged shareholders. Yet, hedging individual stocks with their respective options can become confusing, time-consumming and commission-intensive. There is an easier method. 

Grouping all your stocks into one basket essentially creates an index that can be hedged with a closely related index product. This is the idea behind program trading and, if done correctly, it can be a cost-effective alternative to the complexities associated with hedging each stock. 

By picking stocks at random, we will illustrate the comparison between hedging with equities and hedging with index puts. 

We picked six stocks at random: Master Card (MA), Intel (INTC), Met Life (MET), Schlumberger (SLB), Oracle (ORCL) and Microsoft (MSFT).  Assume we purchased 100 shares of each, and we hedged those shares with one put option. The strike selected for both the index and equity options was closest to 5% out-of-the-money, though we could use any strike depending on our goals. The puts, stock prices, etc. will be taken from the closing marks on Feb. 29, 2012, with April expiration (51 days remaining). 

The stocks picked at random all fall into the S&P 100 Index (OEX), so we will use that index, which closed at $619.45, to hedge. The OEX, like many, has a 100 multiplier, thus one put contract will protect a $61,945 portfolio of stocks. 

“Bucketing your basket” shows the randomly chosen stock portfolio and the OEX index per the parameters described.

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The total value of the stock portfolio ($62,404) is very close to the value that one OEX put ($61,945) protects. Also notice that if we bought one put for each stock, the total cost of the stock’s insurance would be $1,242.50 as opposed to the relatively modest $660 for the OEX protective put — $642.50 (or 52%) less. 

There is a concern over how the index put compares to the individual puts should the market decline sharply. For demonstration purposes, if we assume the market declines all the way to zero, the returns would be extremely similar: $59,350 for the individual puts and $59,000 for the OEX put. 

We know that is not going to happen, but the two different methods of hedging protect roughly the same amount of investment dollars should something severe occur, and at a lower cost. 

This example is a remedial one used to illuminate how closely the index put compares to hedging in many different names to achieve roughly the same ends. A correlation analysis needs to be done between your portfolio and the universe of appropriate indexes and sub-indexes. Once you find one that is a close fit, you can save substantial time and money hedging your portfolio. 

M. Burkhardt is the CEO of options education firm Random Walk, LLC, which offers other free education on their website: RandomWalkTrading.com.

About the Author
M. Burkhardt is the CEO of option education firm RandomWalk Trading. Additional educational material is available at randomwalktrading.com.