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Keep Your Options Close, Your Hedge Closer

There's also another hedging solution, one that is much more broad and simplistic: Buying index puts. If you don't own more than 100 shares in specific securities, or don't want to have them exercised out of your account (for instance, because of tax reasons) then you can look to the indices for protection. Broad portfolio insurance, while less specific to your portfolio, is also cheaper, since the commission rates will be lower and you won't need to replicate it for each stock.

By purchasing put options on the S&P 500 ETF (SPY), for instance, we can protect against a broader market selloff. Again, for simplicity, let's say we are trying to protect a $50,000 portfolio that currently has a beta equal to 1. Let's use the SPY, again for simplicity.

Beta greater than 1 would mean more put options are needed and beta less than 1 means less put options are needed, with a beta of 1 being equal to the S&P 500. For example, if you had a beta of 2, you would need twice as many put options to offset the move in your portfolio, relative to the S&P 500. Conversely, if your portfolio had a beta of 0.5, you would need half as many puts.

Back to our example. For a $50,000 portfolio, we would need just over 3 SPY puts to insure the portfolios. This number is calculated by dividing our portfolio value by the value of the SPY. With the SPY ETF trading close to $163, this would equal 306.74, ($50,000 / $163 = 306.74). Think of this as 306 shares of the SPY.

Technically, we would need 3.06 puts, since each put option represents 100 shares. But since we cannot buy six-one-hundredths of a put, we'll just round down to three. Currently, the SPY at-the-money $163 June quarterly put costs $3.15. Multiply this by the three puts we need and we come up a total cost of $945, excluding fees.

Considering that indices continue to make all-time highs and that we've gone so far, so fast, it wouldn't make sense to be blind to a correction. However, you don't want to miss upside momentum and you certainly don't want to be stuck in cash or in bonds.

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