Married Puts: Tying the Knot
Vow to protect your portfolio with this straightforward strategy.
The past week provided a nice bungee-like bounce. But are you prepared for the next plunge down?
The broad indices are up some 7-10% from their lows, and many individual stocks, such as Morgan Stanley (MS), General Electric (GE) and Chevron (CVX), are up some 20-40% from their recent lows.
What precautions can you take to prevent your nest egg from cracking if the line -- call it 710 in the S&P 500 Index -- fails to hold?
Let's assume a typical equity portfolio contains a combination about 25 holdings -- that range from individual stocks to exchange-traded funds and mutual funds -- that basically represents and tracks the S&P 500 Index (SPX).
Married to Index Puts
Unlike many other factors in the hedging decision process, this one isn't open to interpretation. For this example, the portfolio is worth $500,000. The most straightforward form of protection is the purchase of puts.
The most important data needed to calculate the necessary number of contracts to protect against a decline, is the current value of the portfolio.
Let's use the Spyder Trust Exchange Traded Fund as a proxy for the S&P 500 Index. The SPY is currently around $75, or a tenth of the SPX's value. Divide the portfolio's value by the SPY's value to determine the approximate number of shares your portfolio represents. In this, a $500,000 portfolio would equate to roughly 6,666 shares of the Spyder Trust.
Since each option contract represents 100 shares, it would require a minimum of 66 Spyder puts to hedge the portfolio. I say minimum because now one needs to decide just how much and what type of insurance they desire.
This means taking into consideration an options delta. Delta refers to the change in the price of an option relative to a change in the price of the underlying stock. Delta is defined by a slope - meaning its value changes as the price of the underlying changes. The further in-the-money an option moves, the greater the delta.
An at-the-money option usually has a delta of 0.50, meaning for every dollar change in the underlying price, the option's value will change by $0.50. If you want to be fully covered -- that is, not incur any loss -- from current price level it, would require a purchase of 132 at-the-money puts.
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