I'm researching the most efficient method of hedging a portfolio of stocks against a major market correction, as I take on some larger long stock positions. After looking at a number of alternatives, I'm attracted to the fact that buying an index put at least locks in my max loss if the market rallies strongly, but gives me a decent downside protection. If you use options (or another vehicle) as portfolio insurance, I'd appreciate your thoughts - specifically on such issues as length until expiration, calculating number of contracts, OTM, ITM, etc.
IMHO: Futures are better hedging tools, as they have lower transaction costs and smaller bid-ask spreads than index options.
Now is clearly a good time to utilze index puts as a hedging tool given the rock-botom volatility levels. Hence, it's "cheap" insurance on a relative basis. In terms of the number of contracts to buy, you'd need to calculate the appropriate hedge ratio based on the position delta of your portfolio. With regard to which series and strike to buy, that's a function of how much risk you want to bear. But as a general matter, I'd suggest buying the strike that's just below an assessed support level. As for time, I see no reason not to use front month options, which are cheaper (though the deltas on near term OTM puts will be less than comparable longer dated puts, thus requiring you to purchase more). And by using front month options, you can keep rolling out and up/down month-to-month as dictated by the underlying portfolio, any change in your market view and prevailing volatility levels.
I definitely agree with Hello Dollars about the current low volitility premium and the flexability of using shorter term. But it depends a lot on your time horizon for the hedge. Sometimes it is better to take less flexability as a trade off against the longer term. It is generally (maybe always) better to buy your time in bulk if you are looking at a longer term hedge. The time decay in the last 20 days is really steep. Also, you pay a lot of commissions and eat a lot of spreads as you roll.
That's a good response and supports my thinking. Thanks. I'm still not set on front or farther month though. Nearer term will of course give a bigger bang for the buck, but higher transaction costs and faster decay. But farther out doesn't provide as much downside protection. Not a clearcut decision, it seems. Time for some serious number crunching. The problem with index futures as a hedge, IMO, is that we are in a confirmed bull market and I don't feel comfortable holding a continiung short position with unknown potential loss. I'm not a huge fan of options, but they do have one nice benefit in that the potential loss is a given, and limited. Futures would be useful just for short term protection, such as overnight, and that's something I'm also looking at.
I have the same question as lindq for the same reason, but I would rather sell calls than buy puts. I am immediately guilty of my own advice which is 'try researching a bit before you ask the board', but c'est la vie. Trust me when I say that my weekend will be all about getting up to speed on selling calls as a hedge, and for income. Any advice is appreciated, including good books to read. Thanks guys.
I assume here that you're taking about covered calls, and not naked. The idea of covering a current stock holding with a short call is interesting with the S&P at such a high level. It might have some merit.
Interesting maybe, but not a hedge. If you want to hedge your long positions, selling covered calls won't do much for you. Much much better ways to go then that.