QUESTION: How can you save time and money in hedging your equity portfolio?
ANSWER: Find an appropriate proxy index and hedge in one market instead of every stock you own.
With the Dow Jones Industrial Average trading above 13,000 in late-February, up 34% from its two-year lows (9,686 on July 5, 2010), many long-term investors may be tempted to take their gains and run. Though the lackluster economy is showing some signs of strength, the recovery is by no means guaranteed, and getting out 1,000 points from the all-time highs seems prudent. More sophisticated investors may opt to lock in their current gains using puts to hedge their individual stocks, thus allowing for the possibility of more share appreciation.
Hedging shares of stocks with puts is relatively straightforward. Because each put allows the holder of the option the right, but not the obligation, to sell the shares at a specific price (strike price), a large decline in the price of the stock is offset by an increase in the price of the put hedge. For every 100 shares of stock, one put contract is required as a clean hedge. Thus, someone wanting to hedge 100 shares of Intel (INTC) will hedge with one INTC put contract.
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: Master Card (MA), Intel (INTC), Met Life (MET), Schlumberger (SLB), Oracle (ORCL) and Microsoft (MSFT). Assume we purchased 100 shares of each, and we hedged those shares with one put option. The strike selected for both the index and equity options was closest to 5% out-of-the-money, though we could use any strike depending on our goals. The puts, stock prices, etc. will be taken from the closing marks on Feb. 29, 2012, with April expiration (51 days remaining).