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.
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.