You can balance your portfolio by investing in options on a stock index, which tracks an entire market or sector.

Index options are puts and calls on a stock index, rather than on an individual stock. For many investors, the appeal of index options is the exposure they provide to the performance of a group of stocks. Holding the equivalent stock positions of one index option — say the 500 stocks in the S&P 500 — would require much more capital and numerous transactions.

Another attraction is that index options can be flexible, fitting into the financial plans of both conservative and more aggressive investors. If you’ve concentrated your portfolio on large US companies, you might sell options on an index that correlates to your portfolio to hedge your investments.

Or, if you feel that the biotech industry is headed for record gains, you could purchase a call on the Biotech Industry Index. Most index options are European style, which means they can only be exercised at expiration, not before.

Hedging your portfolio

Conservative investors may use index options to hedge their portfolios. If your portfolio drops in value, an index that corresponds to the movement of your portfolio will drop as well. By purchasing a put on that index, you’re entitled, at expiration, to an amount of cash proportionate to the drop of the index below the strike price.

Index Options

The 900 put reduces the total loss by 5%

For example, say you have $100,000 invested in a portfolio that contains some of the larger stocks in the broad-based XYZ Index, which is currently trading at about 950. You’d like to protect yourself against a loss of more than 5%, or $5,000. You purchase a 900 put on the XYZ Index. In the next few months, your portfolio drops in value by about 10%, to $90,000.

Since XYZ has a similar makeup, it has also dropped by a little more than 10%, to 850. Your put is now in-the-money by 50 points, and at expiration you receive $5,000 minus the premium you paid for the put and any sales charges. Your overall loss is reduced to about $5,000, or 5%, which was your predetermined acceptable level. Keep in mind, though, that what you pay for the put affects your return. If the index doesn’t drop before expiration, your option will remain out-of-the-money or at-the-money. You can decide whether to extend your hedge by buying another option with a later expiration, or rolling out.

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Index options leverage

Index options also appeal to investors because of the leverage they provide. Investors can participate in moves for a fraction of the cost of purchasing the equivalent assortment of stocks. And even a small change can result in large percentage gains. The downside of leverage, of course, is that if the market moves against expectations, the percentage loss can be high, and might be all of your investment.

The leverage of index options also means that if you’re confident a certain sector is going to make gains, but you don’t know which individual stock will rise, you can purchase an index call to benefit from the broader market shift.

How to calculate the number of contracts for hedging?

If you’re using index puts to hedge your portfolio, you’ll have to calculate the number of contracts to purchase in order to match the size of your portfolio.

1. Determine the current aggregate value of the index option:

______ Current index value x $100 = Aggregate value

2. Divide the value of your portfolio by the aggregate value.

______ Your portfolio’s value

÷ Aggregate value from above =____________

The result is the number of contracts that will protect your entire portfolio. Once you’ve determined the number of contracts that will cover your portfolio, you should calculate how much downside protection you want. The strike price you choose should match that amount, so that the insurance will kick in if the index drops that far. For example, if you want to protect against a decline greater than 10% in your portfolio, your strike price should be 90% of the current value of the index, which would be the value of the index if it drops 10% from current value.

What’s the risk?

The risk of buying index options is the same as the risk of buying stock options: It’s limited to the amount of premium you pay.

If you’re considering buying a put, it’s important to weigh the cost of hedging your portfolio against the benefits of the hedge. Index options writers, however, face the substantial potential risk. Since the value of the index might drop suddenly, a put writer might owe a lot of cash. The same risk applies to a call writer, if the index increases sharply. And index call writers usually can’t cover themselves by holding the underlying instrument, as they can with individual stock options. margin considerations.

The margin considerations

The margin requirements are different for writing index options than for writing options on individual equities. In general, you initially need to deposit the entire premium, and at least 15% of the contract’s aggregate value, or the level of the index multiplied by $100, in your margin account. Since the aggregate value of an index option changes daily, the amount of the margin maintenance requirement fluctuates, which means you’ll need to pay close attention to your account to avoid a margin call.

If your goal is to hedge your portfolio with index puts, the key is to find an index that mirrors the movement of your portfolio. Otherwise, what happens to the index won’t accurately reflect what happens to your portfolio, and you may not offset any of its declining value. The first step is to find indexes that cover the same market or sector as your portfolio.

Once you’ve narrowed your choices, you might use the past performance of an index or judge its volatility to find one that closely mirrors your portfolio’s movement. But unless your portfolio exactly matches the makeup of an index — which is very unlikely — you’ll always face the risk that it won’t move the same way your portfolio does.

Hedging Your Portfolio With Index Options by Inna Rosputnia

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