Hedging With Stock Options

Hedge Calculator

If you're concerned about a correction in the stock market, there are steps you can take to help preserve and protect your wealth. You can buy index puts as a hedge against market decline.

Index puts are purchased because they will generally increase in value as the market declines, counteracting the loss in your stock portfolio. Buying puts allows you to participate in the upside of the market while insuring against downward moves. However, if the correction or drop doesn't happen by option expiration, you've got another decision to make: whether to replace the expiring options with options expiring further out in time.

Here's a hypothetical hedging scenario:

You have a $100,000 stock portfolio.
The S&P 100 Index (OEX) stands at 725.
You're concerned about the months of April and May.

Since each OEX option contract represents 100 units, you multiply the index by 100.

725 × 100 = $72,500.

Your portfolio's value divided by the index value will give you the number of puts needed to hedge.

$100,000/$72,500 = 1.37 put option contracts.

Obviously, you can't buy a portion of a contract, so you'll need to choose either more or less protection to fit your needs. If you don't feel you need the entire portfolio hedged, you could buy just one option.

Buy one May 725 strike put option. A May 725 put is currently offered at 18.

Figure your cost this way: 1 × 18 × 100 = $1,800. If you buy two contracts, the cost formula is 2 × 18 × 100 = $3,600.

This hedge will give you the right to collect the amount by which the OEX falls below the 725 strike through May expiration. Should you, however, choose to sell your hedge before expiration, you could probably do so at a substantial premium to the amount that the index is below the strike price.

If the much-anticipated 20% correction occurs, the OEX would drop to 580. Here are the numbers:

100% - 20% loss = 80%
80% of 725 = 580
725 - 580 = 145 points below the strike—or in-the-money, as we call it in the industry.
145 × 1 put × 100 = $14,500—or, if you bought two contracts, 145 × 2 puts × 100 = $29,000.

$14,500 collected from one put
- $1,800 cost of one put contract
=$12,700 to counteract or offset the loss in the stock portfolio.

A 20% decline in a $100,000 portfolio would be a loss of $20,000, which would be offset by the $12,700 collected from the one put. This would bring the total loss to $7,300.

If you bought two option contracts:

$29,000 would be collected
-$ 3,600 cost of two put contracts
=$25,400 to counteract or offset loss in the stock portfolio.

Since the total loss was only $20,000, you'd actually profit from the decline if you purchased two put contracts: $25,400 - $20,000 = $5,400.

Naturally, this is all based on the assumption that your diversified stock portfolio will perform like the S&P 100 Index. Also, remember that taxes and commissions will affect your portfolio.