Portfolio Hedging With Index Puts

Volatility, as measured by the VIX Index, has finally winded down from the absurd 89.53 high it hit this past November. It’s current reading (33.12 at last glance) is still high by historical measures, but at these levels and lower, it becomes less expensive to hedge a portfolio with index puts.

For another look at volatility and the VIX index, check out this Geldpress article about high volatility.

There are several ways to hedge positions in a portfolio, including:

Those hedges protect a single position, but for general protection for an entire portfolio, an index put is the method to use. The idea is simple, and involves just a few decisions:

Which index to use for protection – The choices are many, including the S&P, Dow Jones, Nasdaq or even some of the sector indexes (healthcare, energy, etc). The general rule is to use the index that most closely matches your own portfolio. Since I keep my own portfolio’s pretty diversified, my personal preference is to use the S&P 500 as an index put hedge.
Which strike price to use for protection – The general guideline for index put protection is to use at the money or slightly out of the money options for general portfolio hedging. More experienced traders will sometimes use out of the money options for index portfolio hedging. My personal preference is to stay at or near the money for hedging and use out of the money options for speculative gambles.
Which expiration month – There is wide debate on this topic, but in general, the answer to this question should match your own trading style. If you are an aggressive day trader, then front month index put options are probably your best tool for portfolio heding. If you are a more hands off long term trader, then long term index put options (LEAPs) are the method for you. My personal style is somewhere in the middle, and I start off with index puts 3-4 months out, and then roll them out when there is only 1 month remaining.
How much protection – Forget the theory. Recognize that index put hedging is expensive, and may cost you several percentage points from your yearly performance. But it may also let you sleep better at night, and allow you to survive repeat performances of the market behavior similar to that of the last year. As a general rule, I will spend 5-10% of my portfolio value on index puts. If that 5-10% buys 5 contracts 3 months out, then that is the baseline. From that starting point, make your own adjustments based on your daily or weekly portfolio performance. If the overall market drops 2.5% in a day, but your account only dropped .5%, then ask yourself if you are satisfied with the protection. If you are satisified, then you have the right amount of protection. If you are not, then add some additional puts to your baseline. If you r account does not increase enough with an overall rally, then perhaps you have to much downside protection. Also recognize that index puts need occasional adjustments, like any other option contracts. For more information on index puts or option adjustments, check out one of the following books.

Put Options : How to Use This Powerful Financial Tool for Profit & Protection by Jeffrey Cohen