Today we continue analyzing our equity portfolio in terms of possible hedging strategies. In the previous note we wrote about the convertibles story for hedging and now we move to option hedging strategies. Mostly we prefer to analyze index option strategies as the simplest and most liquid way. Lets consider buying Index Puts to Hedge the Value of a Portfolio. Protective puts are commonly used by equity investors for protection on the downside of the value of underlying shares they own. As the index goes down, the value of the protective puts can increase, potential profits on the puts can be realized by either selling the contracts or exercising them if in-the-money, with these gains at least partially offsetting any decline in portfolio value. The puts limit the portfolio loss to a specific level depending on their strike price in relation to the underlying index level when the protective option position is established. On the upside the portfolio’s profit potential is unlimited, but any profits are at least partially reduced by the initial cost of the puts. The break-even point on the upside will be the current portfolio value when it is insured plus the cost of the puts. All index options are cash-settled. We have a portfolio of mixed stocks worth $1 mil and in our case we want to look at S&P500 index. With the current level of such index, we for example want to buy those indexes puts to protect the portfolio from a market decline of 5% over the next 90 days. We might determine the number of puts to purchase by dividing the amount to be hedged by the current aggregate value of indexes. This number of contracts should be adjusted according to the beta of the portfolio’s performance against the index (in our case it is near 1,5 on average) as it does not track the underlying index exactly. An more conservative alternative to selling index options to hedge a portfolio is to sell index calls while simultaneously buying an equal number of index puts. Doing so will lock in the value of the portfolio to guard against any adverse market movements. This strategy is also known as a protective index collar. The idea behind the index collar is to finance the purchase of the protective index puts using the premium collected from selling the index calls. However, as a result of selling the index calls, in the event that the fund our expectation of a falling market is wrong, our portfolio will not benefit from the rising market. Now about implementation of such strategy. To hedge a portfolio with index options, we need also to first select an index or indexes with a high correlation to the portfolio we wish to protect. For instance, our portfolio consists of partly of technology stocks, so the Nasdaq Composite Index might be a good fit and if the portfolio is made up of mainly blue chip companies, then the Dow Jones Industrial Index could be used. For our portfolio, we prefer using S&P500 index, as we have said before. After determining the index to use, we calculate how many put and call contracts to buy and sell to fully hedge the portfolio using the following formula: No. Index Options Required = Value of Holding / (Index Level x Contract Multiplier) We may decide to hedge our holding, for example, for 90 days by purchasing slightly out-of-the-money S&P 500 index puts while selling an equal number of slightly out-of-the-money S&P 500 index calls expiring in 3 months' time. The current level of the S&P 500 is 2072 and the MAR 1968 SPX put contract costs approximately $20 each while the DEC 2175 SPX call contract is quoted approximately at $25 each. The SPX options have a contract multiplier of $100, and so the number of contracts needed to fully protect our portfolio is: $1 000 000 / (2072 x $100) = 4.82 or 5 contracts. A total of 5 put options needs to be purchased and 5 call options need to be written. So if the market retreat by the declining S&P 500 index, the value of the put options rises and almost fully offset the losses taken by the portfolio. Conversely, should the market appreciate, the rise in his holding's value is capped by the rise in the value of the call options sold short. Hence, once the index collar in entered, the investor has effectively locked in the value of his portfolio. So we prefer to use such kind of hedging only in times of high volatility and only for a short period of time.