Step one: The first step is to get an understanding of the size of your portfolio. Simply add up the total dollar value of the stocks you own.
Step two: Find the index that most closely matches up with your group of stocks. If most of your stocks are small growth companies, then the Russell might be a good choice as a hedge. If you have broad exposure to the market, then the S&P 500 would work. Larger cap companies in your portfolio might make the Dow a more viable product via the DJX (1/10th mini Dow index) or DIA (an exchange-traded fund) index. The DJX would be the best option for our portfolio (below).
Step three: Because options on stocks and indexes typically have a 100 multiplier, we need to multiply the price of the index you are using by 100. Then simply divide the total dollar value of your portfolio by 100 times the index you are looking to utilize as a hedge. If your portfolio is worth $35,663.52, you simply divide this number by the DJX value of $135.71 (as of Oct. 5) X 100, or 13,571 (Portfolio / (Index X 100); $35,663.52 / (135.71 X 100) = 2.6 options.)
This means that you will need to purchase either two or three puts to hedge this portfolio. Most people round up in bearish times and round down in bullish.
Step four: Find the appropriate put in the index to purchase for a hedge. Though an at-the-money put will provide the most protection, it also is the most expensive (in terms of time value) and you are not trying to eliminate all risk, just risk of ruin. For this reason most people go slightly out-of-the-money. Although there are statistical methods you can implement to select the best put, many people look at a 5% to 8% window.
With the DJX at $135.71 on Oct. 5, the November 133 put (with 43 days until expiration) is trading at $1.50. Three put options will cost $1.50 per share X 100 shares per contract X 3 contracts, or $450.
That gets quite expensive to maintain constant protection so we will look to sell calls or call spreads against this to offset most of the cost — thus creating a cashless collar. This simply is a long put and short call that protects long stock. It is usually done for as close to no cost as possible.
Suppose that the market crashed 10% between now and expiration, causing the DJX to close at $122.14. Our portfolio of stocks also would drop by about 10% if diversified (some stocks more and some less). The value of the portfolio would now be about $32,097.17, a $3,566.35 loss. Yet our 133 puts would be $10.86 in-the-money. This recoups almost our entire loss because $10.86 of intrinsic value X 100 multiplier and 3 contracts = $3,258.
Although this was an oversimplification of the process, actual hedging is not much more difficult. Choosing the right index, expiration month and strike prices can go a long way to protect your portfolio the next time an MF Global, Enron, Lehman Brothers or Wachovia occurs.
J.L. Lord is an analyst and author for RandomWalkTrading.com.