Personal Investing: Using Options to Hedge Your Portfolio

For investors worried about a prolonged market sell-off, options have become a popular strategy to hedge your portfolio.

While options typically are used for individual stocks--giving you the right to buy or sell a security at a set price--more investors are buying options on market indexes and exchange-traded funds to protect against a broad market decline.

“The question that most people are asking me these days is ‘How can I hedge my portfolio?’” said Michael Schwartz, chief options strategist at Oppenheimer. “Buying index put (sell) options is a strategy that can be used in anticipation of a market decline to provide partial protection for a portfolio of stocks."

AP Chicago Board Options Exchange

Here’s how the strategy works: By buying an option contract to sell an index or ETF at a particular price--known as a put--you essentially put a floor on any losses. Each put gives you the right to sell 100 shares at a specific price within a certain time frame. In addition, if the underlying index or ETF declines, the value of your put rises. So you can sell the put to someone else and use the profit to offset losses in your portfolio.

Using puts “doesn’t mean investors have turned from bullish to bearish, but there is certainly a lot of prudence in using protection if the market does decide to change direction,” said Randy Frederick, director of derivatives at Charles Schwab. “The nice thing is that it will help people from losing a lot of money (in a potential downturn) and from keeping the market from going down as much as it could.”

That’s because instead of selling their shares, investors tend to sell their puts, which eliminates some selling activity in the actual stocks.

The only downside associated with the strategy is the costs of the puts. It’s best viewed as a traditional insurance premium -- you don’t necessarily want to use the insurance, but the premium is a necessary cost.

Creating a Hedge                                                            

When creating a hedge against the broader market, many investors choose ETF options instead of index options. That's because ETF options are cheaper, are sold in smaller increments and are more liquid.

For instance, if you’re looking to hedge a portfolio that correlates closely with the S&P 500, it’s often easier to use options on the corresponding ETF than the index itself. The most widely- used ETF is Standard & Poor’s Depositary Receipts, known as the Spiders, which trade at one-tenth the value of the S&P 500 index.

So if you want to hedge a $100,000 portfolio against any major market decline this summer, you might buy September 150 Spider puts, each of which provides the right to sell 100 Spider shares

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[SPY  Loading...      ()   ] at $150 per share through the third Friday in September. The puts were recently trading at $3.70, but since each put gives you the right to sell 100 shares, they cost about $370. The investor needs about six contracts to roughly cover their portfolio, so the total cost is $2,250.

If the S&P were to plunge 10%, you would have only lose about 3.7% on their portfolio, or about $3,700 instead of $10,000. The savings isn't as dramatic if the market dropped 5%, but you still come out ahead. Instead of losing $5,000, you're only down $3,700.

"You can hedge relatively cheaply while still having the upside exposure," said Price Headley, founder and chief analyst at BigTrends.com, an options research firm in Lexington, Ky.

Using puts is also a good alternative if you don't want to sell shares for tax reasons. However, it's wise to consult with an advisor when using these strategies.

In addition to Spider puts, investors are also buying puts in the Dow Diamonds, an ETF tracking the Dow Jones Industrial Average, as well as in the Powershares QQQ, which tracks the Nasdaq-100 Index and is known by its trading symbol QQQQ, said David Kalt, chief executive officer of OptionsXpress, an online brokerage.

The use of puts also reflects, in a sense, a more mature investing public, some experts said.

“It has nothing to do with speculation, it has to do with protecting gains in the market,” Frederick concluded. “Investors are much wiser and smarter, and the reason you don’t see the kind of euphoria you saw in 2000 is because people got burned back then. Now, they are being more pragmatic.”

Tara Siegel Bernard is a News Editor at CNBC.com. She can be reached at .