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VIDEOProtect Your Portfolio: SPY on It
A three-step approach to the best hedging strategy.
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Dear Professor Smith,
I’ve recouped a lot of money during this recent rebound, and I want to protect those gains. For portfolio-insurance purposes, am I better off buying a slightly out-of-the-money put versus a way-out-of-the-money put? For instance, am I better off buying Spyder Trust (SPY) December '09 puts with strike at 87 (near current price) versus 70 (near March low)? (More expensive of course: $9.85 versus $3.85.)
With regard to how much, let's say I want to insure $150,000. I take current SPY price of 87 times 100 divided into $150,000 and get 17 contracts.
Minyan James B.
Dear Minyan James B.,
This previous article, Married Puts: Tying the Knot, discussed how to use an option's delta to calculate the number of option contracts and strike prices that will provide the desired level of protection.
Buying put options does offer the most complete and probably efficient way to hedge a position, but it comes at a cost. And that cost, as with all insurance policies, will be a function of the amount of protection and its duration.
The main items to consider when choosing put protection -- whether for an individual stock or a broad equity portfolio -- are:
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1. What magnitude of a decline is expected?
2. At what level of the decline do you want the position to be fully hedged or protected?
3. For what length of time do you want the protection in place?
Answering these questions will help you determine the appropriate number of puts to buy at a given strike price with a certain expiration date.
A great tool can be found at SchaeffersResearch. Its portfolio calculator lets you play around with various levels of put protection for a portfolio of stocks representative of the S&P 100 Index.
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