Hedging a Portfolio with Index Options
Buying index puts as a cheap seatbelt for a whole portfolio in a crash.
Buying a putThe right, not the obligation, to buy or sell at a set price. on every stock you own would be expensive and clumsy. The efficient way to protect a whole portfolio is to buy putsThe right to sell the underlying at a set price — a bearish bet. on a broad *indexA basket of stocks tracked together to represent a market.* (like the NiftyA basket of stocks tracked together to represent a market.) — one clean trade that acts as a seatbelt for your entire equityA unit of ownership in a company. exposure.
IndexA basket of stocks tracked together to represent a market.-putThe right, not the obligation, to buy or sell at a set price. hedgingTaking an offsetting position to reduce risk. works because, in a crash, almost everything falls together — correlations spike toward 1 (recall the correlationHow closely two assets move together. lessons). So a single indexA basket of stocks tracked together to represent a market. putThe right, not the obligation, to buy or sell at a set price. can offset the broad-market portion of your portfolio’s loss, far more cheaply and simply than hedgingTaking an offsetting position to reduce risk. each stock. You buy index putsThe right to sell the underlying at a set price — a bearish bet. sized to your portfolio’s market exposure (betaHow much a stock moves relative to the market.-adjusted), and they pay off precisely when you need it most — a market-wide plunge. It’s the one seatbelt for the whole car. The cost is the premium drag (insurance is never free), which is why portfolio hedges are usually putThe right to sell the underlying at a set price — a bearish bet. on selectively — ahead of feared events or in fragile markets — rather than worn permanently. And it only covers market (systematic) risk, not a single stock blowing up on its own.
- Setup — buy indexA basket of stocks tracked together to represent a market. putsThe right to sell the underlying at a set price — a bearish bet. (e.g. NiftyA basket of stocks tracked together to represent a market. putsThe right to sell the underlying at a set price — a bearish bet.) sized to your portfolio’s value and betaHow much a stock moves relative to the market., so the hedgeTaking an offsetting position to reduce risk. roughly matches your market exposure.
- Why indexA basket of stocks tracked together to represent a market. — in crashes correlations spike, so one indexA basket of stocks tracked together to represent a market. putThe right, not the obligation, to buy or sell at a set price. hedges many stocks cheaply; far simpler than per-stock putsThe right to sell the underlying at a set price — a bearish bet..
- Limits — covers systematic (market-wide) risk, not stock-specific blowups; premium is an ongoing cost, so hedgeTaking an offsetting position to reduce risk. selectively.
ExampleYou hold an ₹11 lakh diversified equityA unit of ownership in a company. portfolio and fearThe two emotions that move markets and ruin accounts. a market shock. Instead of 15 separate putThe right, not the obligation, to buy or sell at a set price. trades, you buy NiftyA basket of stocks tracked together to represent a market. putsThe right to sell the underlying at a set price — a bearish bet. covering ~₹11 lakh of indexA basket of stocks tracked together to represent a market. exposure. A 10% market crash hits your stocks for ~₹1.1 lakh, but the index putsThe right to sell the underlying at a set price — a bearish bet. gain roughly the same — one trade cushioning the whole portfolio.
Key takeawayHedgeTaking an offsetting position to reduce risk. a whole portfolio by buying *indexA basket of stocks tracked together to represent a market.* putsThe right to sell the underlying at a set price — a bearish bet. (sized to your value and betaHow much a stock moves relative to the market.) — because crashes make stocks fall together, one indexA basket of stocks tracked together to represent a market. putThe right, not the obligation, to buy or sell at a set price. cheaply offsets broad-market loss. It’s a single seatbelt for the portfolio, covering systematic risk only, with a premium cost — so use it selectively.
FAQs
How much of my portfolio should I hedge?
It depends on your risk tolerance and conviction — you can hedge fully (match the full beta-adjusted exposure) or partially (cushion the worst of a fall while keeping some upside). Because hedges cost premium, many investors hedge *partially and selectively* (around events or in fragile markets) rather than fully and permanently.