Here is a great little video from Larry McMillan on how to go about using options – and potentially even weekly options – to hedge a portfolio against downside risk.
The way he suggests doing this is by using a technique that the ‘pros’ use called ‘Macro Protection’ where you buy an index option to protect your whole portfolio rather than trying to buy puts or other forms of ‘hedges’ for each one of the stocks or underlings that you might hold – because doing it that way can be just too time consuming and tedious.
He goes on to say that it is very likely that any particular portfolio will most likely behave similar to one of two indexes – either the SPX or the Q’s. Then it is just a matter of determining which one of those indexes your own portfolio behaves most like – and then going in and using one of those – either the SPX or the Q’s.
Traditionally what the market makers – or the ‘pros’ – would do is they would go in and buy SPX (or Q) puts about ten percent out of the money – purchased about 3 months out (expiration day is about 3 months away from where we are trading today) – and then just roll them over once expiration approaches.
He goes on to talk about a study he was involved in where they did this over a long period of time – they would buy SPX puts ten percent out of the money – 3 months out – over time it wound up costing them about 2 percent of their net asset value per year – making it a fairly low cost form of portfolio insurance. And then in a case like the crash of 2008 – or even this latest 2011 crash debacle – those SPX (or Q) puts are going to make a good amount of money to counter the loss on your portfolio.
In the video he also gets into what he refers to as ‘dynamic’ hedging where instead of using SPX or Q puts – one can simply just purchase VIX calls. We’ll get more into that in our next post – or you can get access to the video in it’s entirety from our resource area by joining our free option income newsletter by clicking here