When you hedge a stock portfolio you protect yourself against an adverse price move in your stocks. In other words, if your stocks drop $1.00 per share, your hedge would have to rise $1.00 per share to offset your loss. A hedge, then, is similar to an insurance policy, insuring you against any major losses regardless of which way the market moves. The most common way of hedging a portfolio of stocks is to purchase an equal amount of puts (options which rise in value when the price of the stock goes down) against your purchased stock. This is extremely easy to do.
Purchase a portfolio of stocks that you have reason to believe will go up in value over time. Purchase all stocks in blocks of 100 shares.
Purchase one contract of put options on each stock for every 100 shares of stock you purchased. In other words, if you purchased 300 shares of XYZ Corporation, then you would need to buy three XYZ Corporation put contracts. Each option contract covers 100 shares of stock. Each put contract will cost considerably less than the value of 100 shares of stock, allowing you to think of the cost of your options the same way you think of a premium on an insurance policy. If the value of your XYZ Corporation stocks drops, the value of your puts will go up, hedging you against any loss.
Purchase at-the-money puts when you hedge. Puts are sold in a variety of what are called strike prices. Buy the puts with a strike price as close to today's value of your stock as possible. In other words, if XYZ is trading at $20 a share you would buy puts with a strike price of $20.
Buy far-month put contracts unless you only plan to keep your stock for a short period of time. Options have expiration dates, which means you should purchase put options which don't expire for several months. The plus side to doing this is that you won't have to worry about hedging your stocks again until the options finally expire (on the third Friday of the expiration month)--the negative side is that you pay an extra premium for the added time you are buying.
Keep up-to-date with your hedging options. Options do expire and when they do you will need to buy new options to replace the expiring ones if you wish to continue hedging your portfolio.
Many people wish you to believe that option prices change at the exact same rate as the underlying stock. In other words, if the stock drops by $1.00 per share then the options will rise $1.00 per share. This is untrue in the real world, but the option price will rise by almost $1.00 and still protect a great deal of the value of your portfolio.
If your portfolio consists of more than one stock, you must buy options tied to each of the stocks in your portfolio to do a proper hedge.
Your profit when you finally sell your shares of stock will be reduced by the premium you paid for your options.
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