The following article has been featured on MarketWatch.com.
One way to handle uncertainty in the markets is to use broad-based options to protect a portfolio of stocks. Ironically, we produced an extensive white paper on the topic of Modern Portfolio Protection in July 2007, which we tried to market to institutional investors.
Our premise was that protection was cheap, and with the market on a very non-volatile four-year run, it was time to take some defensive action for stock portfolios.
That was right near the top of the market, and -- surprise -- no one was interested in our thoughts on using options to protect their stock portfolios. Within a month, "subprime debt" had become nearly a household word, and the beginnings of what became a major bear market and financial crisis had occurred.
Now, with the market having rallied 70% off its March 2009 bottom, we are re-visiting the subject -- albeit in less detail this time.
There are several ways that an investor can hedge a large portfolio of stocks with derivatives, but there are really only two ways that make much sense. "Macro" protection means that you buy broad-based index options as a hedge to your long stock portfolio. You can thus protect your entire portfolio with just one option trade. The biggest risk in this approach is "tracking error" -- that your portfolio might not perform the same as the index does.
Sometimes, simplest is best, and that is probably the case here. There are two approaches that one could take: either buy puts on the Standard & Poor's 500 Index (SPX 1,182, -3.19, -0.27%) or buy calls on the volatility index (VIX 20.71, +0.49, +2.42%). Either one of those would appreciate in value if the stock market were to take another major downward hit.
In my opinion, the purchase of VIX calls is a much better, more dynamic way, to approach protection. That is because VIX will explode whenever the market declines sharply, no matter where the S&P 500 is. But if you buy SPX puts today and then a large rally ensues before a large decline occurs, the striking price of your SPX puts is likely to be so far out of the money as to do you no good during the declining phase.
To continue reading the story, visit: http://www.marketwatch.com/story/protect-your-entire-portfolio-with-one-trade-2010-06-29