How To Hedge Your Portfolio With Put Options

Hedging with put options

There’re a lot of kinky stuff going around the Indian stock markets.

Low GST collections/compliance, the Trump-Jong Mexican standoff, Fed interest rate hikes, huge bank NPAs, low earning forecasts, uncertainty about when growth will pick up, risk of downgrades — and any one or a combination has the potential to stick a pitchfork right up a bull’s arse.

This can happen suddenly, despite being in a bull market, and end up wiping out solid percentages of portfolio value. The sell-off on Diwali 2017 trading day was a case in point.

Therefore it makes sense to insure your portfolio at a small price instead of riding through the risks.

Let’s take an example. Let’s say your portfolio value is worth Rs 10 lakhs and the market is passing through uncertain times, like it is now.

One important thing to note at this moment is that this strategy must be practiced in times of market uncertainty and not when the trend is clear.

Step 1: Choose the expiration date — today is 23 October 2017, and there would be no point buying put options for October-end expiry. It would make sense to choose Nov- or Dec-end as an expiration date. 

Step 2: Choose the index — You must choose an Index that is decidedly weak. For example, as things stand, the Bank Nifty looks weak and in fact, it is the last pillar of support for the Nifty 50. You cannot choose Nifty IT because the dollar is expected to rise against the Rupee. Nifty Mid Cap 50 is not that liquid, so let’s zero in on either the Nifty or the Bank Nifty.

In this example, I chose the Nifty Put Option of 9500 for 30 November 2017. At the time of writing this article it was available at 21.

Step 3: Before You Buy — In this example we have assumed a portfolio of 10 lakhs. One lot of Nifty Options is 75 units.

Therefore, the value of the lot we have chosen is 9500 X 75 = 7,12,500

Therefore, 2 lots will more than cover the value of your entire portfolio.

Now let’s say we buy 2 lots of Nifty 9500PE @ 21.

Our investment will be Rs 3,150 (Rs 21 X 75/lot X 2 lots).

3,150 represents just 0.32% of the portfolio, and if you keep doing this every month, it works out to approximately 4% of your portfolio FOR THE ENTIRE YEAR.

Step 4: After You Buy — Do not consider this put option as a trade. Write off its price just like you would write off an insurance premium. Hold and wait. In case you sell off a part of your portfolio, and wish to square up, you can always sell one lot and hold on to the other.

Buying put options to protect your portfolio in an uncertain market environment is an excellent tactic that helps you sleep peacefully at a small price. In any case, you do expect your portfolio to appreciate by leaps and bounds every year and therefore paying 4% of its value as insurance works out to actually nothing.

This is one tactic I follow and thought I’d share it with all.

Image Courtesy: NY Times

13 Comments on "How To Hedge Your Portfolio With Put Options"

  1. I dont trade in options but this suggestion seems to make a lot of sense. Tks…

  2. Very well explained…Only issue is individual stocks can crash by 20 to 30% .. strategy works very well if one focusses on index stocks

  3. should one do it for the whole year at once on keep being the puts every month for the same month expiry ?? please explain .. coz “..the markets can remain irrational longer than one can remain solvent !!” we might never know when the market will fall and more over more than 85% of puts expire worthless as per historic data .. thanks for sharing the hedging strategy ..

  4. Eye opener indeed is your article Sir. Could you please guide me on how to select the Strike price for buying Puts. Please consider a scenario as on 30.11.2017.

  5. Sir, please bear with my query. As mentioned in above blog post, on 23 Oct Nifty closed at 10184. I couldn’t figure out why you bought put options for 9500 strike instead of ATM 10200 Strike option. I went through your tool. But couldn’t select the right strike. Looking forward for your valuable guidance to protect/insure my portfolio of midcap stocks.

    • Instead of watching the premium, catch the trend. For example when the IT sector started trending puts were available at paise for very low strike prices. These did not make any sense in an options premium calculator. But when the fall started, the premiums gave a 500%-1000% return.

      In any case, I buy puts to hedge my PF, not to trade. Once bought, I don’t care about the rates because I would rather have that insurance.

  6. I think that the best strategy is buying puts when the relative volatility is low and the price of the option is inexpensive. With a diverse portfolio of good quality dividend stocks that I can stand a 20% decline before protection kicks in; I prefer to buy January puts if the cost for a given delta is cheaper than buying monthly puts and rolling every month. Also a January put gives you the option of selling the put in December for tax planning. Out of money puts provide wedge protection in that the lower the price of the stock goes the better the protection becomes on a non linier basis.

  7. Sir how to protect portfolio with high beta mid and small cap stocks, my pf value is 20 lacs rt now ( it was 30 in January ), what put should i buy now and how much? My pf beta comes out to be 1.4 i think

  8. Tarun Dasani | July 31, 2020 at 6:34 pm | Reply

    Sir – how should we select the PE Strike price?

    • sunil.tinani | August 3, 2020 at 3:42 pm | Reply

      If you are very bullish, choose your SL as the OTM PE strike price. If you are not bullish buy an ATM or one leg down PE.

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