Puts Can Be Expensive

A reader was kind enough to share a very comprehensive plan for hedging his portfolio as he is concerned that the market might correct sharply and he asked my opinion on what he has in mind.

He plans to buy puts on 1/3 of his portfolio that expire in January 2007. He did not say whether he plans to buy puts on individual stocks or on an index. He also did not indicate if he would be buying in the money puts or out of the money (I doubt in the money but he did not say). If he wants to buy out of the money puts, how far out of the money? That is an important question. As a hedger with puts are you will to give up 5% or 10% or some other number before the puts kick in?

Looking at S&P 500 puts that expire in December (there are no Jans) with a strike of 1285, the offer was $33.10 at the close yesterday. One put would hedge $128,500 worth of stock. For a $500,000 portfolio buying four puts would be about right for a hedge for the entire portfolio. The spread is quite wide, lets say that they can be bought for $32. To hedge 1/3 of the portfolio the reader would need to decide between one and two puts so it will cost him $3200 or $6400.

I have no idea if this is what the reader has in mind but if it is you can get a feel for the numbers. December expiration is December 16 (I realize that is a Saturday, options technically expire on Saturdays). What if the market starts falling on Dec 18?

Being right on trend and wrong on time is a common pitfall to option trading.

If the reader plans to buy puts on individual stocks it will cost more money. Also, I am making an assumption that the S&P 500 would be the puts he wants to use but if portfolio is too far, in composition, from the index it may not be a great hedge.

If the reader can let the market fall 10% before a hedge kicks in, the closest strike would be 1175 and those would cost $12 ($1200) per put.

Depending on when and how the market drops (assuming it does) the puts, even the 1175s, could go up in value before going in the money. There are all sorts Greek letter that can help you figure out some probabilities but those are future events and so are unknown.

I don't know if this is really worth doing or not for other people. I have no interest in buying puts in the manner the reader has outlined. It is cheaper and, IMO, easier to change the make up of the portfolio, use an inverse index fund or raise cash.

The important thing is that the reader has an exit strategy. That it is not something I would do is irrelevant. I have been saying all along that all exit strategies have pluses and minuses.

Good for this reader that he has some specific action planned.