Protecting a Diversified Portfolio

So what are you worried about?  If you’re a Cub fan you’re worried all the time!  That I can’t help you with because you should be worried.  But how about your $300,000 stock portfolio?  It’s been a nice run but now you’re thinking all good things got to come to an end.  For example, let’s say you are worried about a 15% to 20% market decline in the next three months. Your goal should be to limit downside risk and keep your upside profit potential intact.  Here’s how the protection works:

First you need to determine the number of SPX (S&P 500) Puts you will need for protection.

SPX @ 1560

Portfolio $Value to be Hedged / Notional Value of Index Contract (Strike x $100)

$300,000 / (1560 x $100) = 2 SPX Puts

Buy 2 SPX June 1560 Puts @ $41.00 ($4,100 per contract)

Total Cost = $8,200 (excluding commissions)

One SPX June 1560 Put protects $156,000

Assume in our example SPX @ 1248  Market is down 20% so portfolio is down 20%  Your $291,800 stock portfolio is now $233,440

SPX @ 1248

1560 Puts @$312.00

Value of Puts: $312.00 x 2 x 100 = $62,400

Total Portfolio: $233,440 + $62,400 = $295,840

The market is down 20% and you are down less than 2%  If you are unwilling to pay for Puts you may consider selling near-the-money calls on stocks that you are willing to sell now. You could sell out-of-the- money calls on stocks that you are willing to sell if the price rises. Or a Bear Put spread may be another consideration to off-set the purchase price of the puts to a certain degree.

There is an old saying in the pits here at CBOE.  Buy Puts when you can, not when you have to.