Portfolio Insurance

Suppose you have an asset whose value (1) goes up when your portfolio value goes down, and (2) goes down, but never below zero, when your portfolio value goes up.  You can use this asset to hedge your portfolio.  When your portfolio decreases in value, it would be offset by an increase in the asset's value.  But the reverse is not true; a rise in portfolio value would not be totally offset by a drop in the asset's value.  Is there such an asset in the real world?  For a well diversified portfolio of stocks, stock funds, or both, this asset is usually a traded index option.  You can generally buy an index option to minimize the downside risk of your portfolio.  Index options are settled in cash, not by delivering the securities underlying the index.  Index options are bought and sold in exchange-traded markets, as well as over-the-counter.  Some indices track the movement of the stock market as a whole, while others follow the performance of a particular sector, such as mining, computer technology, utilities, etc.  In the US, options on S&P 100 and S&P 500 are popular and traded at the Chicago Board Options Exchange.  The options on the S&P 500 are European, whereas those on the S&P 100 are American. 

If you are thinking of using an index option to hedge your portfolio, you should first run the Hedge menu of Portfolio Designer.  It helps you answer the following essential questions:

• Should I buy put or call option?   

• How many contracts should I buy?

• How much should I pay for them?

• How sure am I that it will work?

• What is the level of protection am I getting?