Buying Puts to Protect a Portfolio – How a Put Option Works
When you are interested in investing your money in riskier contracts or stocks, you might want to think of hedge or put options to start protecting your portfolio. A put is a contract between two parties who agree to exchange an asset at a specific price, by a specific date. The buyer of the put has the right to sell this asset at the strike price by the time the future date rolls around, while the seller is obligated to buy this asset. Buying puts to protect a portfolio can be a good idea because the investor will purchase enough puts to cover their holdings, so if the market falls suddenly they will still be able to sell their holding at the predetermined strike price.
In this way, buying puts to protect a portfolio is a certain type of insurance. Because the markets have fallen in recent years, many investors are leery of putting all their money in one area or looking at riskier stock options, and may want to protect the investments that they do have with the put option. This is a way to avoid losing everything should the market tumble further still. If selling of stocks continues, then those who hedge their options will have the best way of fighting back.
In addition to buying puts to protect a portfolio, another option is selling calls. Buying puts is a more proactive way to protect your investments, however, because they work harder. To get started, you can ask your broker about buying puts on your individual stock holdings, or buying index puts. There is software out there which can calculate the ideal number of puts for your portfolio, or you can do a rough calculation on your own. The first step is to start with the approximate dollar value of your portfolio, and then divide this by the price of the put index, and then add in a factor that gives you some amount of room to mess up.
Many managers use a factor of 3%, but there are many different factors or amounts of leeway that you can give yourself when you go about buying puts to protect a portfolio. Once you have purchased this form of financial insurance, you can decide to let the puts sit in your portfolio. Another option is to browse the stock charts, and buy puts when you feel that the market is about to break. Be sure to ask a financial professional for advice regarding how this can work for you.