Hello Steven,
I enjoy your writing regarding option strategies, and hoped you could provide some input on the following. I am considering allocating a small portion of my portfolio each quarter to some type of "portfolio insurance." ... I am thinking about longer-dated puts, perhaps on the S&P Depositary Receipts (SPY) - Get Report or Nasdaq 100 Trust (QQQ) - Get Report. However, I understand these are typically very expensive instruments to buy options on. I have also thought about choosing two to four "bellwethers" rather than the indexes. I am in the very rough stages of this thought process and would sincerely appreciate any input you might have. Thanks in advance for your kind consideration.
--Christopher B.

Given that the

S&P 500

has fallen some 5% in just the last five weeks and is now down over 2.5% for the year to date, and given that the

Nasdaq Composite

has tumbled nearly 12% in just the last month and is now more than 9% lower in 2004, it's not so surprising that questions concerning portfolio insurance have been coming in with increasing frequency.

Some people may even take this as a contrary indicator and a sign that the stock market is approaching a bottom. But because the Options Forum column is not in the prediction business and in this case offers protection suggestions, one can only hope that it isn't too little, too late.

Before exploring the various means one can use to hedge or insure an existing portfolio or position, be aware that despite its popularity, the SPY currently has no directly related options contract. The only options with a direct tie and correlation to the S&P 500 benchmark are traded exclusively on the Chicago Board of Option Exchange.

The story is too tangled to get into here, but suffice it to say that existing licensing agreements between Standard & Poor's parent company



and the various stock and option exchanges are the reason behind the missing product and lack of dual listings. The issue is becoming increasingly contentious: The International Securities Exchange has been petitioning the SEC for over two years, alleging monopolistic and anticompetitive markets. It's not likely to be resolved until the current agreements expire over the next two years.

Meanwhile, there are still plenty of options available for hedging, protecting or locking in certain prices for existing holdings. Indeed, there are numerous exchange-traded funds and other index options that can be used to match and correlate with the holdings or weighting of your portfolio.

The reader is on the right track in identifying the purchase of put options as the most straightforward form of protection, or "insurance." But it's important to recognize that "expensive" and "cheap" are very relative terms, especially when applied to option valuation.

Like all insurance, the cost depends on two basic elements: the current value of your holdings and the amount of protection desired. These two very identifiable quantities should be the starting point for your calculation in determining the number of put contracts that should be purchased. The concepts behind this

broad portfolio protection calculator can be applied to broad measures such as the

Russell 2000 iShares

(IWM) - Get Report

or an individual stock.

To save you some time plugging in the variables, here are some tips.

Unless you think the stock (market) is declining steeply and soon, it's more cost-efficient to buy longer-dated options. This is a function of:

  • The fact that theta time decay accelerates as options approach expiration date.
  • An option's delta, or the expected change in the option's theoretical value per unit change in price of the underlying asset, is slope-based. It is theoretically 0.50 for at-the-money options and incrementally higher for options with more time remaining until expiration. A position's total delta is calculated as the cumulative sum of its parts.

Let's use the

Semiconductor HOLDRs

(SMH) - Get Report

to illustrate how you can combine these concepts to hedge holding 500 shares of the Semi HOLDRs, or about $15,500 worth of chip stocks (understanding that depending on the individual stocks held, the correlation will vary), and you want to be fully protected for anything beyond a 5%, or $1.55, drop in price.

That means if the Semi HOLDRs drop to $29.45, you want the option position to have a delta minus 1.0 relative your current long position. With the Semi HOLDRs currently trading at $31, buy 16 of the November $30 puts for $2 per contract (they have a delta of 0.31, for a total of $3,200), or buy 14 January 2006 puts, a delta of 0.36, at $4.10 per contract, or a total of $5,710, to be fully hedged if the Semi HOLDRs drop below $30 per share.

But while the November puts might seem cheaper in absolute dollars, note that if the SMH holds or hovers above $30 for the next six months and you replaced that put protection on a quarterly basis, it could cost you $12,000 per year -- nearly 75% on an annualized basis. The January 2006 puts work out to a 24% on an annualized basis. That's still not cheap, but it's certainly less than the quarterly cost.

In this way, the cost to hedge a portfolio has an inverse relationship to the life of the contract and the expected market decline. Again, the reason for the steep cost reduction over time is related to an option's delta, as a function of the security's price (vega) and the time remaining until expiration (gamma).

One way to equalize or reduce the impact of time decay, potential changes in volatility or overall cost would be to use vertical spreads -- that is, the purchase of puts and the simultaneous sale of an equal number of puts with the same expiration but a strike price that is further out of the money.

Take a look at this

article on other hedging techniques such as collars for protecting profits and limiting downside risk.

One strategy that has not worked would be buying volatility or VIX futures on the premise that as prices decline, the volatility would increase sufficiently to offset losses in the underlying price. With the S&P 500 down 8% since its March high of 1163, the November VIX futures contract has only gained 3% to 210 during the same time period.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to