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The 6-Week Options Trading Kickstarter: Hedging, Portfolio Protection, and Avoiding Disaster

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Steve Smith discusses using options to protect your positions and portfolio.

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Answering these questions will help you determine the appropriate number of puts to buy at a given strike with a certain expiration date. By using the basic application of delta, in which an at-the-money option is expected to move $0.50 for every $1 unit price move in the underlying security, one can begin to asses how much and at what levels cost protection can be purchased.

A great tool can be found at Schaeffers.com. 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 (^OEX).

Combination Approach

If you're really looking for a true, longer-term hedge -- that is, you don't expect to make many changes or adjustments to your portfolio for six months or more -- using a combination of strategies might make sense.

For example, I suggest the following three-step approach, which uses SPY options to create portfolio protection for a $150,000 portfolio:

1. Buy a put spread of closer to-the-money strikes that have about six months remaining until expiration. With the SPY trading around $140, one can buy the January $135 puts and sell the January $125 puts. Such a spread could be bought for around $2.50 net debit. For a $150,000 portfolio, purchasing about 100 of these might provide reasonable protection. But because we're protecting it in two other ways (read on), buying 25 spreads should suffice.
No positions in stocks mentioned.

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