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Know How to Protect Your Basket? Consider Using Options

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July 12, 2013
Know How to Protect Your Basket? Consider Using Options

Options aren’t always for speculation. Just as we insure our homes and cars, options can be used to offer some protection for a limited period.

For decades, professional money managers have been discouraging investors from “putting all your eggs in one basket.” While that may be sound advice for many, as your investing strategy changes, or your portfolio grows, you may in fact find yourself sitting on a valuable basket of stocks, with little exposure to other asset classes like bonds, cash, and real estate.

Or maybe you just don’t have very many stocks in your portfolio, which means you’ll feel even the smallest price changes ripple through your limited share sample. If stocks are where you expect to find the best opportunities, perhaps you should be asking, “How do I help protect my basket?” In a word: puts. Specifically, buying put options may provide some price protection for those sophisticated investors who understand, and are comfortable with the risks involved.

Stock Protection 101—Line That Basket

Put options don’t have to be confusing. In fact, if you insure your home, your car, or your precious Persian kitty, you may already own policies that are similar to owning puts. For example, for a car, you select an insurance policy for a certain amount of coverage for a specific period of time. If the sky falls and your car goes with it, the car may be worthless, but that auto policy costing $1,000 suddenly becomes worth a whole lot more. Owning a put option is a similar concept. A put owner has the right to sell the underlying security at the strike price for a limited period of time. Sadly, many investors with portfolios worth far more than their cars and homes combined, leave themselves exposed to unnecessary risk.

While there’s no hard-and-fast rule, on a basket of portfolio stocks many investors buy puts that correlate to a broad index (such as the S&P 500 or Nasdaq 100) at a cost somewhere in the neighborhood of 3%-5% of the value of their securities on a semi-annual basis. But don’t let that scare you. There are ways to bring the cost down without leaving your wallet bare.

How Much Do You Need?

An important aspect to assessing the correct amount of limited protection (or “hedge”) is to find the index that closely resembles the stock mix in your portfolio. In other words, the index should closely “correlate” with your basket. If your basket is balanced across sectors, this might be the S&P 500 (SPX), or the S&P 100 (OEX). If it’s weighted in big-cap technology, the Nasdaq 100 (NDX) might be a better fit, and so on.

Once you’ve figured out which index best correlates to your portfolio, you’ll need to calculate just how many puts you need to buy. Suppose your hypothetical stock portfolio worth $500,000 contains a dozen or so different large-cap stocks that can be found in OEX.

At this point, using put options on OEX, you might be able to create a hedge with the following formula:

1. CALCULATE THE CASH VALUE OF THE INDEX
The “cash value” of OEX is an average of all 100 stocks that comprise the index. It’s calculated using a multiplier of 100 (which happens to be the multiplier on most indices). On June 12, 2012, the index closed at 606. Therefore, the cash value of OEX is: 606 X 100 = $60,600.

2. DETERMINE HOW MUCH OF A HEDGE YOU’LL NEED
Simply divide your hypothetical portfolio value by the cash value of the hedging index, to get the number of puts needed: $500,000 ÷ $60,600 = 8.25. Rounded down, you’d need to consider at least 8 OEX puts to hedge your hypothetical portfolio.

3. CALCULATE YOUR FINAL HEDGE COST
Next, decide how far out in time you want to protect, say, a minimum of 3 months, and choose where you’d like your greatest amount of protection—perhaps near the price of the index. (The farther away your put is from the index price, the cheaper it gets. The higher the strike, the more expensive it gets.) On June 12, the September 600 strike put option was $26.00. The cost of your transaction would be calculated as number of puts x put price x 100: 8 x 26 x 100 = $20,800 (plus commissions and fees).

How Do You Pay For It? Cover ‘Em

Of course, there’s always the possibility you don’t have $20,800 at your disposal. And you may not want to sell part of your portfolio to raise the cash to buy the hedge either. There’s another option strategy to consider using to help subsidize the hedge without breaking the bank:

You could consider selling calls against each of your stock holdings. Since you own the stock, this is known as selling “covered calls.” Provided you own a minimum of 100 shares of stock per call you sell, you’re “covered,” and may not need to incur additional margin requirements.

The net proceeds of all the calls sold may further reduce the cost of your put hedge. However, watch out for the caveats. If the stock price moves beyond the short-call strikes, your stock will likely get “called away” (your stock will be sold out of your account at the strike price) and possibly trigger a taxable event, if you have gains in the stock. Keep in mind that most short options can be assigned at any time up to expiration regardless of the in-the-money amount. Also, be sure to take into account the transaction costs involved in selling covered calls on those stock positions.

And next… scrambled eggs or souffle?

What Happens Next?

Market Declines. Should the portfolio or stock decline in value, typically, the index you’ve hedged against (in this case, OEX), will likely decline in value as well, thus increasing the value of your puts. Ideally, the rise in value of these puts will offset the decline in your portfolio value. At any point prior to expiration of the puts, you would simply close out your hedge, and the net proceeds are swept into your account. At this point, you might decide to use the gains to buy more stock at cheaper prices, or simply put on a new hedge at the index’s lower prices. Maximum potential reward for a long put is limited by the amount that the underlying can fall. This strategy provides only temporary protection from a decline in the price of the corresponding index. Should the long put position expire worthless, the entire cost of the put position would be lost.

Stock vs. stock with put hedge

FIGURE 1: Protecting an egg: As this profit/loss curve shows, with a stock + put position (solid line), maximum risk is now clearly defined and, like the stock (dashed line), you still have unlimited upside potential. However, your breakeven now increases. Should the put position expire worthless, the entire cost of the put would be lost. For illustrative purposes only.

Market Rises. On the other hand, should the markets continue to rise and as OEX moves higher, because of the convex nature of options, your hedge will begin to lose less than your portfolio gains as OEX moves further away from the put strikes. In the case of the covered-call technique, if any of the stocks climb higher than the strikes at which you sold calls on them, there’s a possibility you could be “assigned,” and forced to sell your stocks at the strike prices. To avoid this scenario, you might consider buying back the calls at the higher price. If closing out the calls isn’t a choice, you might simply wait to have your stocks “called away.” You’ll keep the cash you received from the sale of the calls, potentially profit on the sale of the stock at the strike price (assuming you sold the stock for more than you paid for it). You lose ownership of the stock and will miss out on any additional appreciation above the strike price.

Hedging with options might be a foreign concept for some. But in today’s uncertain investing climate, you just might find that the potential protection it offers is well worth your time. And, perhaps the next time your financial advisor talks to you about eggs and baskets, you might want to tell her, “Thanks. I have it covered.”

Consider Your Options

Apply for options approved trading at tdameritrade.com.
Go to: Trade > Options > Click the Apply Online Now button at the bottom of the page.

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