In two recent articles, I've explained some key facts about an option's delta and why investors need to understand it. A number of readers said they found the topic helpful, and several of them asked for more information on hedging and protective strategies. So I'll oblige.

While there's really no such thing as a perfect hedge, one of the purest means of locking in a given price (and hopefully a profit) is a collar. I discussed this position in some detail in a

previous column, but I'll provide a review of how it works.

Keeping Profits

A collar, which is also known as a conversion, is the simultaneous purchase of a put and sale of a call, with both having the same strike and expiration. This can be done in conjunction with a new stock purchase, but the strategy is typically used to lock in a profit of an existing long position. Remember, this relates to the at-the-money put and call both having a 0.50 delta with a cumulative value equal to being short 100 shares.

For example, assume you own 1,000 shares of XYZ. Suppose the stock has posted a healthy gain over the past few years and is currently trading at $80. You want to lock in a minimum sale price, but for a variety of reasons you don't want to sell the actual shares at the moment.

A purchase of 10 XYZ $80 puts and the sale of 10 XYZ $80 calls would theoretically lock in a sale price of the stock at $80. The goal is to have the sale of the call finance the purchase price of the put.

Your market view and timing considerations will help determine which strikes and expirations to use. For instance, assume XYZ happens to a biotech company. The Food and Drug Administration is going to make a decision on a new drug in the next few weeks, and you want to protect against a possible unfavorable recommendation from the agency. In this case, a short-term collar (options that expire within 30 days) would be appropriate.

If, on the other hand, you're still fundamentally bullish on your XYZ holding, you might want to use longer-dated options and adjust the strike prices. If you bought 10 XYZ January 2005 $75 puts for $5 and sold 10 January 2005 $85 calls for $5, you would be expanding your maximum sale an additional $5 to $85. But you would also be lowering your minimum sale down to $75. (This isn't a collar in the strictest definition. However, you're still effectively "collaring" the sale price, only with a wider range.)

Another item to keep in mind is that while a collar locks in a specific sale price, it also ties up capital during the life of the position. This speaks partially to why there is no perfect hedge. The money (margin or otherwise) needed to maintain the collar position is essentially dead money, whereas the proceeds of a sale of the long stock could be redeployed, even if it's at the current paltry money market rates.

Collars are a great solution to specific stock holdings in which you have specific price targets. But now let's take a quick look at how to assess the hedging or protective requirements for a broader portfolio.

Know the Costs

Let's assume a collective stock portfolio contains a combination of individual stocks, exchange-traded funds, mutual funds and a 401(k) account. We'll say this fictitious portfolio is essentially a representation of the

S&P 500

. The most straightforward form of protection is the purchase of puts. The most important data needed to calculate the necessary number of contracts to protect against a decline is the current value of the portfolio. Unlike many other factors in the hedging decision process, this one isn't open to interpretation.

The portfolio in this example is worth $500,000. As of midday Friday, the current price of the S&P 500 was 900. Since each S&P option contract represents 100 units, you multiply the index (900) by 100 and get a value of $90,000. Now divide the portfolio's value by the index value to determine how many puts would need to be purchased for hedging purposes. In this case, it would require a purchase of 5.5 at-the-money puts.

This formula can also be applied to other optionable baskets such as the

Semiconductor HOLDRs


Biotech HOLDRs

in order to refine your protection to a specific sector.

Since you can't buy one-half of a put, deciding between buying five or six is just the first of the many decisions to be made. The next is the time frame or expiration date you wish to purchase. In other words, how long do you want your insurance policy in place? The length of the contract will determine the cost of the put. Put protection doesn't come cheap, with the current rate in the S&P 500 running at about 12% annually. In this sense, any form of portfolio insurance is in some way a function of a market-timing strategy.

So it's important to note that the number of puts required, and therefore the related cost to hedge a portfolio, has an inverse relationship to the life of the contract and the expected market decline. If you wish to protect the example portfolio from a 5% market drop for just 30 days, it would require the purchase of about 13 May 900 puts at the cost of $1,700 each for a total of $22,100. That's an annualized rate equal to more than 50% of the value of your portfolio.

By contrast, the 5.5 contracts calculated above are based on a 10% decline using puts with at least three months remaining. For example, the September 900 put can be purchased for $4,500 each, or six for $27,000, for an annualized rate of protection of 12.9%. The reason for the steep reduction in cost over time is related to an option's delta, the change in the underlying security's price (vega) and the time remaining until expiration (gamma).

Protective put purchases should be used for longer periods of time in order to effectively offset a steep decline in price, while allowing for gains should prices rise. But a collar is traditionally used to lock in a sale price within a very narrow range. The tradeoff is that a collar costs little more than the time value of money, whereas the outright purchase of puts can take quite a bite out of your portfolio.

The bottom line is that the best use of options employs a dynamic element, such as multiple strikes and spreading strategies, to reach a balance between reducing costs and minimizing risk.

Steven Smith writes regularly for 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 May 1989 to August 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

Steve Smith.