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Option Basics - Portfolio Protection

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In our three part segment on Risk Management, we previously discussed Option Basics - Position Size and Option Basics - Asset Protection. In this segment, we will discuss how to properly protect a large portfolio of assets.

When you have a large number of assets to protect against a general downturn in the market, the most efficient approach is to collar the portfolio. This is accomplished by using index options, like the SPX or SPY (ETF), and is called the index collar.

There are two approaches to determining the number of index contracts needed for proper protection. The first is used if your platform cannot perform portfolio Beta weighting. It relies on the formula: # contracts = portfolio value / (100 x Current price of index)

Note: if the value of the portfolio is small, then use the SPY (especially if the number of contracts falls below 10); else use the SPX to reduce overall transaction costs.

The second approach uses portfolio beta weighting. The purpose of beta weighting is to establish a common beta value (the index) when calculating an asset's delta; thus providing a good approximation of how assets will react to changes in the overall market. The beta weighted deltas are then added together to provide the portfolio delta.

Under this approach, we can determine the number of contracts needed to bring the portfolio's delta to near zero (preferably slightly negative). Since the collar adds negative delta to the portfolio, it would only apply if the portfolio has significant positive delta; if it does not, then there is no need to apply portfolio protection, and you should only look to each asset individually for possible asset protection.

Let's look at an example.

We have a portfolio consisting of multiple large-cap stocks with a value of $1 million, and we are concerned that the market will continue its move down for the next six months (or more). The S&P500 is currently at 1500.

Using the formula above, the number of SPX contracts needed would be: 1 million / (100 * 1500) = 67 SPX contracts.

The cost for 67 contracts of the Put DEC12 1475 @ $20 is $134k. The premium received for the 67 contracts of the Call DEC12 1525 @ $25 is $167k. The net premium received is $33k ($167k - $134k), so the insurance is not costing anything, but actually bringing money into the account.

From the table above, we can see how the index collar effectively minimized the impact of a down market while limiting upside potential. If greater protection to the downside was needed with less impact to the upside, simply use the protective Put without the sale of the Call; however, the total cost of the Put would be incurred if the market never dropped below 1475 by contract expiration.

In conclusion, the simplest most effective way to protect a portfolio of assets is the collar using either the SPX or SPY index options.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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