Hedging with Index Options
An alternative to selling index futures to hedge a portfolio is to sell index calls while simultaneously buying an equal number of index puts. Doing so will lock in the value of the portfolio to guard against any adverse market movements. This strategy is also known as a protective index collar.
The idea behind the index collar is to finance the purchase of the protective index puts using the premium collected from selling the index calls. However, as a result of selling the index calls, in the event that the fund manager’s expectation of a falling market is wrong, his portfolio will not benefit from the rising market.
To hedge a portfolio with index options, we need to first select an index with a high correlation to the portfolio we wish to protect. For instance, if the portfolio consist of mainly technology stocks, the Nasdaq Composite Index might be a good fit and if the portfolio is made up of mainly blue chip companies, then the Dow Jones Industrial Index could be used.
After determining the index to use, we calculate how many put and call contracts to buy and sell to fully hedge the portfolio using the following formula.
No. Index Options Required = Value of Holding / (Index Level x Contract Multiplier)