Portfolio Hedging Strategy with Index Options

You’ve been sleeping under a rock if you’ve never heard the adage, “Don’t put all your eggs in one basket”—sage advice for the buy-and-hold investor but Greek to most traders. (What’s a basket? Are you selling me egg futures?) If you’re an option trader and also plan to own a diversified basket of stocks for the long haul, this might be a good time to stretch your knowledge and learn how to put on a portfolio hedge using index options.

Please note that options trading involves significant risks and is not suitable for everyone. Certain requirements must be met to trade options through TD Ameritrade. Not all clients will qualify.

Stock “Protection” 101

You probably know that puts are often used by option traders to speculate if they believe a stock price or the market in general is going down, or to help protect a position in case the stock or market goes down. The latter—trying to protect a single stock position—is simple. But it gets a little more complicated when you size up an index put to hedge a basket of stocks.

Let’s back up a minute. Put hedges are simple in principle. If you insure your home, your car, or your precious Persian kitty, you probably own insurance policies that, in theory, work similarly to puts. You’re well aware that if the sky falls and your car is a pancake, the car may be worthless, but that auto policy you spent $1,000 on suddenly becomes worth a whole lot more. In fact, you get to “put,” or transfer, the cost of the car replacement to your insurance company.

Puts give traders the right to sell their underlying stock at the strike price for a limited time (until the option expires). If you own index puts, there’s no underlying stock deliverable. They’re “cash settled.” So, at the expiration of your long index put, if your puts are in the money (put strike is higher than index-settlement price), you’d receive the cash difference between the price where the index ended up and the put strike. This cash becomes part of the asset value of your portfolio. It may not correlate perfectly (i.e., dollar-for-dollar cash gained per dollar lost in your stocks), but it can certainly help make a stock loss less painful.

How Much Do You Need?

There’s no hard-and-fast rule, but you might expect to spend between 3% and 5% of your portfolio value on each hedge. Don’t let that scare you. There are ways to potentially bring the cost down so you don’t empty your wallet.

When assessing the correct amount of limited protection (or hedge), first find an index that closely resembles (correlates with) the stock mix in your portfolio. If your basket is balanced across sectors, consider using the S&P 500® index (SPX), as shown in Figure 1. If it’s weighted in big-cap technology, the Nasdaq-100® (NDX) might be a better fit, and so on.

Once you’ve snagged the best correlating index, calculate how many puts you need to buy. Suppose your hypothetical stock portfolio worth $250,000 contains a dozen or so different large-cap stocks that can be found in the S&P 100® index (OEX).

At this point, using OEX put options, you might be able to create a hedge using the following steps.

1. Calculate the index’s cash value The cash value of OEX is an average of the 100 stocks in the index. It’s calculated using a multiplier of 100 (which happens to be the multiplier on most indexes). On October 13, 2022, the index closed at 1659. Therefore, the cash value of OEX was $165,900.
2. Determine the number of puts to buy Simply divide your hypothetical portfolio value by the cash value of the hedging index to get the number of offset deltas you need to be fully hedged: $250,000 ÷ $165,900 = 1.51 (or 151 deltas). Here, delta measures the degree for which a put might offset a dollar loss in the underlying. (See Delta: A Little Goes a Long Way for more on delta hedges.) Typically, at-the-money (ATM) put options have a delta near -50. So, to put on an ATM hedge for this position, you’d likely need approximately three ATM OEX puts to hedge your hypothetical portfolio, which is near -150 deltas. Close enough.
3. Calculate the cost of your hedge Next, decide how far out in time you want protection, say, a minimum of three months, then choose where you’d like your greatest amount of protection to be—perhaps near the index price. On October 13, the 1660-strike option expiring in 99 days was $92. The cost of the transaction would be calculated as the number of puts times the put price times 100 (3 x $92 x 100 = $27,600).*

How It All Plays Out

Stocks decline

Should your portfolio decline in value, the correlating index you’ve hedged against (in this case, OEX) will likely decline in value as well, increasing the value of your puts. Ideally, you want the increase in the put value to offset the decline in your portfolio value. At any point before the puts expire, you could likely close your hedge, and the net proceeds would be swept into your account.

You might decide to use any gains to buy more stock at cheaper prices, or simply put on a new hedge at the index’s lower prices. The maximum potential return for a long put is limited by the amount the underlying can fall. Remember, 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.

Stocks rise

On the other hand, should the markets continue to rise and as OEX moves further away from the put strikes, your hedge will begin to lose less than your portfolio gains. That’s because of the “convexity” of options during the life of the trade. Figure 2 shows what happens to your position at expiration, without considering convexity, when there’s no time premium left in the hedge—in which case, your effective cost is now the stock price plus the put price.

How Do You Pay for It?

Of course, there’s always the possibility you don’t have $27,600 at your disposal. And you may not want to sell part of your portfolio to raise the cash to buy the hedge.

Cover ’Em

You might consider selling calls against each of your stock holdings to offset some of the put hedge’s cost. Provided you own a minimum of 100 of the underlying stock shares per each call you sell, you’re “covered” and may not need to incur additional margin requirements. The premium you get from the calls reduces the cost of your put hedge. If the calls you sell are the same distance from the stock price as the put hedge, the credit you receive could potentially offset the entire cost of the put. Your new position is now a “collar” on the stock. For more on collars, see Volmageddon: How to Trade a Crash.

But watch out for caveats. If the stock price moves in the money (ITM) beyond the short call strikes, you could be “assigned” and get your stock position called away. Keep in mind that short options can be assigned at any time up to expiration, regardless of the ITM amount.

To avoid assignment, 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 from the sale of the calls and potentially profit on the sale of the stock at the strike price (assuming you sell the stock for more than you paid for it). But you’ll also lose ownership of the stock and miss out on any additional appreciation above the strike price.

Even traders need protection. But if hedging with index options seems foreign to you, consider it as simply adding a new dimension to your put strategy—in other words, an indirect way to hedge your holdings. The key is to make sure that whatever index you might choose correlates well with your portfolio.

The covered call strategy can limit the upside potential of the underlying stock position, as the stock would likely be called away in the event of substantial stock price increase.  

*No commission fee for U.S. exchange-listed stocks and options. A $0.65 per contract fee applies for options trades with no exercise or assignment fees. Orders placed by other means will have higher transaction costs.