Creating Highly Effective Hedges With Index LEAPS

Hedging risk has a number of benefits and can be accomplished by using stock index futures. For every shares of stock, one put contract is required as a clean hedge. It is outside the scope of this paper to say what happens if one replicates an option using the wrong quantity ex: Leave this field blank. There is no change in the value of the other assets in the portfolio. Though the lackluster economy is showing some signs of strength, the recovery is by no means guaranteed, and getting out 1, points from the all-time highs seems prudent. Plus, I'll help you learn how to hedge stocks that don't have tradable option contracts.

Portfolio Hedging using Index Options An alternative to selling index futures 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.

Definition

Calculate and Justify the Cost The third step in creating an effective hedge using index LEAPS is calculating how many protective puts you should purchase to create the hedge, which can be done in two simple steps:. Once you have the number of option contracts needed, you can look at the options table to find at-the-money puts at various expiration dates.

Then, you can make a few key calculations:. Finally, you can determine if the cost of the hedge is worth the downside protection that it offers at various price points and time frames using these data points.

Since each option accounts for shares, we need to purchase 20 protective puts. Once you've purchased a hedge for your portfolio, it is important to regularly monitor it to adapt to any market changes. In the end, these adjustments will largely depend on your future outlook and goals mentioned in the first step of the process above and involve the same calculations mentioned above.

Using the simple three-step process mentioned above and monitoring the position over time can help investors limit their downside while leaving unlimited upside potential intact to meet their investment objectives.

A Cost Effective Alternative. Motivations for Hedging a Portfolio Since most investors are saving for retirement , they often subscribe to the " buy-and-hold " mentality, using a combination of index and mutual funds. Calculate and Justify the Cost The third step in creating an effective hedge using index LEAPS is calculating how many protective puts you should purchase to create the hedge, which can be done in two simple steps: Divide the dollar value of your holdings by the price per share of the index.

Round that number to the nearest and divide by Then, you can make a few key calculations: Adapting Positions to Market Changes Once you've purchased a hedge for your portfolio, it is important to regularly monitor it to adapt to any market changes.

There are three key scenarios to consider: The Fund Rises — If the underlying fund moves higher, you will likely need to roll up your LEAPS index puts to a higher strike price that offers more protection.

The Fund Stays the Same — If the underlying fund remains the same, you may still need to roll-out hedge to a later expiration date, if any time decay has occurred. The Bottom Line Using the simple three-step process mentioned above and monitoring the position over time can help investors limit their downside while leaving unlimited upside potential intact to meet their investment objectives. Investors and traders utilizing equity options to hedge and enhance their portfolio performance have been able to avoid some of the nastier blow-ups of the last decade.

Certainly anyone hedging Enron, WorldCom, Bear Stearns or Lehman may have taken a hit, but not the total disaster of unhedged shareholders.

Yet, hedging individual stocks with their respective options can become confusing, time-consumming and commission-intensive. There is an easier method. Grouping all your stocks into one basket essentially creates an index that can be hedged with a closely related index product. This is the idea behind program trading and, if done correctly, it can be a cost-effective alternative to the complexities associated with hedging each stock. By picking stocks at random, we will illustrate the comparison between hedging with equities and hedging with index puts.

We picked six stocks at random: Assume we purchased shares of each, and we hedged those shares with one put option. The puts, stock prices, etc. Hedging your equity portfolio with a stock index option By M. How can you save time and money in hedging your equity portfolio? Page 1 of 2. About the Author M.

Motivations for Hedging a Portfolio

Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be. Hedging risk has a number of benefits and can be accomplished by using stock index futures. Futures A futures contract is the obligation to purchase or sell a specific underlying product on a . Hedge ratios of stock index options are ex- pected to reduce two types of risk: systematic risk of the portfolio and risk of futures hedging, for which reason it.