U.S. Markets close in 4 hrs 23 mins

How to get the hedge you want

Chris McKhann (chris.mckhann@optionmonster.com)

Hedging is a good idea. As I have said countless times, you insure your house and your car, but most don't bother insuring their portfolios, which should ultimately be worth more.

Even so, how much to hedge is a key question. That is one of the reasons that we introduced our Hedge Zone system.

Many traders want to cover all of their exposure, which is easy enough when you are hedging directly. For instance, if you own 1,000 shares of Apple, you can buy 10 puts. This is exactly like buying insurance, as it has an term (expiration), a premium, and a deductible.

The deductable in this case is the difference between the stock price and the strike price. Any losses below the strike price of the puts is covered, as that is where you have the right to sell AAPL shares regardless of how far they fall. (See our Education section for more on protective puts .)

For most people, however, buying individual puts on every holding is too time-consuming and capital-intensive. So they purchase puts on an index, rather than an individual company stock, but some math is required to calculate how much to hedge in this case.

Let's assume that you own $100,000 in large-cap stocks in the S&P 500. With the SPDR S&P 500 Fund (:SPY) trading around $198, you buy puts at the 190 strike.

Calculation: Divide the amount of this investment by the strike price of your options multiplied by 100. In chalkboard terms, that looks like this: 100,000 / (190 x 100).

That comes to about 5.3, which, when rounded, is the number of puts you could purchase for protection. This would give you a nice hedge if something bad happens, which tends to be the case far more often than expected in the markets.

It is important to remember that these SPY puts won't give you a 1-for-1 hedge, as we can see clearly in the delta of the options. Using the AAPL example, we could buy the 95 puts with the stock right at $100. As of this writing, those puts in the September expiration are just $0.90 and have a delta of -0.21.

The delta tells us that if AAPL falls from $100 to $99, our options will make only $0.21. The delta would then be higher. The gamma tells us that the delta would then be around -0.26, so a drop from $99 to $98 would push the price of the puts up another $0.26.

Yet this might not be enough of a hedge for some investors, especially if a big move is expected in the near term. In that case, you alternatively can open a "delta neutral" position that can profit if AAPL moves sharply high or lower.

For AAPL, the easiest way to do that would be to use the 100 strike puts, which have delta of -0.50. So if you have 1,000 shares of AAPL, you would buy 20 puts. That would give you delta of -1,000 in the puts (20 x -0.50 x 100, the option multiplier).

The delta-neutral position is essentially a type of straddle , which can be a great trade when volatility is low and you expect it to jump. This is the position I use when the data suggests that we might get a big pullback.

No matter what strategy you choose or the size of the hedge, it is well worth the time and effort for some peace of mind in protecting your portfolio.

(A version of this article appeared in optionMONSTER's Advantage Point newsletter.)

More From optionMONSTER