Using Options to Hedge Equity Portfolios
Using Options to Hedge Equity Portfolios
Options provide flexible tools for protecting equity portfolios against market declines. Put options establish a floor on portfolio value, while collars finance protection by selling upside. Understanding strike selection, cost tradeoffs, and hedge ratios is essential for effective portfolio protection.
Definition and Key Concepts
Hedging Strategies Overview
| Strategy | Structure | Cost | Protection | Upside |
|---|---|---|---|---|
| Protective put | Long put | Premium paid | Full below strike | Unlimited |
| Collar | Long put, short call | Reduced/zero | Full below put strike | Capped at call strike |
| Put spread | Long put, short lower put | Reduced | Partial (between strikes) | Unlimited |
| Put ratio | Long 1 put, short 2 lower puts | Reduced/credit | Partial + downside exposure | Unlimited |
Hedge Ratio Basics
Beta-adjusted hedge ratio: Puts needed = (Portfolio value × Beta) / (Index level × Contract multiplier)
Example:
- Portfolio: $10 million
- S&P 500: 5,000
- Portfolio beta: 1.1
- Contract multiplier: 100
Puts needed = ($10,000,000 × 1.1) / (5,000 × 100) = 22 contracts
Key Tradeoffs
| Factor | Low Strike Put | High Strike Put |
|---|---|---|
| Premium cost | Lower | Higher |
| Protection trigger | Market must fall more | Immediate protection |
| Probability of payout | Lower | Higher |
| Return give-up | Less | More |
How It Works in Practice
Protective Put Setup
Step 1: Determine hedge level
- Full hedge: 100% of portfolio value
- Partial hedge: 80% or other percentage
Step 2: Select strike price Common choices:
- ATM (100%): Maximum protection, highest cost
- 95%: 5% deductible, moderate cost
- 90%: 10% deductible, lower cost
- 85%: 15% deductible, minimal cost
Step 3: Select tenor
| Tenor | Cost (annualized) | Roll Frequency |
|---|---|---|
| 1 month | Higher | 12× per year |
| 3 month | Moderate | 4× per year |
| 6 month | Moderate | 2× per year |
| 1 year | Lower | 1× per year |
Step 4: Execute hedge Purchase puts in calculated quantity.
Collar Strategy
Structure:
- Buy put at lower strike (protection)
- Sell call at higher strike (finances put)
Premium calculation: Net cost = Put premium - Call premium
Zero-cost collar: Find call strike where premium received = put premium paid.
Worked Example
Portfolio details:
- Value: $5,000,000
- Benchmark: S&P 500 at 5,000
- Beta: 1.05
- Hedge horizon: 3 months
- Protection level: 95% of current value
Hedge ratio: Contracts = ($5,000,000 × 1.05) / (5,000 × 100) = 10.5 → 10 contracts
Option prices (3-month):
| Strike | Put Premium | Call Premium |
|---|---|---|
| 4,750 (95%) | $85 | N/A |
| 5,000 (ATM) | $140 | $140 |
| 5,250 (105%) | N/A | $90 |
Strategy 1: Protective put (95% strike) Cost = 10 contracts × $85 × 100 = $85,000 As % of portfolio = 1.7% for 3 months = 6.8% annualized
Strategy 2: Zero-cost collar Buy 4,750 put: $85 × 10 × 100 = $85,000 (cost) Sell 5,250 call: $90 × 10 × 100 = $90,000 (credit) Net: $5,000 credit (or approximately zero-cost)
Scenario Analysis
Scenario: Market falls 15% (5,000 → 4,250)
| Strategy | Unhedged | Protective Put | Collar |
|---|---|---|---|
| Portfolio value | $4,212,500 | $4,212,500 | $4,212,500 |
| Put payoff | $0 | $500,000 | $500,000 |
| Call obligation | $0 | $0 | $0 |
| Premium cost | $0 | -$85,000 | ~$0 |
| Net value | $4,212,500 | $4,627,500 | $4,712,500 |
| Loss | -15.75% | -7.45% | -5.75% |
Scenario: Market rises 15% (5,000 → 5,750)
| Strategy | Unhedged | Protective Put | Collar |
|---|---|---|---|
| Portfolio value | $5,787,500 | $5,787,500 | $5,787,500 |
| Put payoff | $0 | $0 (expired worthless) | $0 |
| Call obligation | $0 | $0 | -$500,000 |
| Premium cost | $0 | -$85,000 | ~$0 |
| Net value | $5,787,500 | $5,702,500 | $5,287,500 |
| Gain | +15.75% | +14.05% | +5.75% |
The collar caps upside at approximately 5% but provides free downside protection.
VaR Impact
Unhedged VaR (95%, 3-month): = $5,000,000 × 15% (assumed drawdown) = $750,000
Hedged VaR (protective put at 95%): = $5,000,000 × 5% (maximum loss to strike) + $85,000 (premium) = $335,000
VaR reduction: 55%
Risks, Limitations, and Tradeoffs
Cost of Protection
Annual put cost as % of portfolio:
| Market Vol | 95% Put | 90% Put |
|---|---|---|
| VIX = 15 | 4-5% | 2-3% |
| VIX = 20 | 6-8% | 4-5% |
| VIX = 30 | 10-12% | 7-9% |
High volatility = expensive protection.
Basis Risk
| Source | Description |
|---|---|
| Beta instability | Portfolio beta changes over time |
| Tracking error | Portfolio doesn't move with index |
| Dividend mismatch | Index option ignores portfolio dividends |
| Rebalancing | Portfolio changes between hedge rolls |
Roll Risk
When rolling hedges:
| Factor | Impact |
|---|---|
| Vol change | Higher vol = more expensive roll |
| Time decay | Must pay for new time value |
| Strike adjustment | May need to adjust for market level |
| Gap risk | Unhedged between expiry and new hedge |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Wrong beta | Using historical beta that changes | Update beta quarterly |
| Ignoring roll costs | Underestimating annual protection cost | Budget for 4+ rolls/year |
| Late execution | Buying puts after market drops | Implement before stress |
| Over-hedging | Hedging more than portfolio value | Verify notional carefully |
Strike Selection Framework
Guidelines by objective:
| Objective | Recommended Strike | Rationale |
|---|---|---|
| Tail risk only | 85-90% | Cheap protection for extreme moves |
| Balanced protection | 90-95% | Moderate cost, reasonable protection |
| Maximum protection | ATM (100%) | Full coverage, highest cost |
| Income-focused | 95-100% + collar | Offset cost with call premium |
Break-even analysis: If put costs 4% annually and market falls 15%: Unhedged loss: -15% Hedged loss: -5% (to strike) - 4% (premium) = -9% Savings: 6% of portfolio value
Checklist and Next Steps
Pre-hedge checklist:
- Calculate portfolio beta to benchmark
- Determine desired protection level
- Select strike price and tenor
- Calculate number of contracts needed
- Evaluate put premium cost
- Consider collar to reduce cost
- Document hedge rationale
Hedge monitoring checklist:
- Track index level vs. portfolio value
- Monitor beta changes
- Calculate time to expiry
- Plan roll timing
- Review protection level adequacy
- Assess cost vs. benefit
Related articles:
- For volatility hedging, see Vega Hedging for Volatility Surfaces
- For concentrated positions, see Protecting Concentrated Stock Positions