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3/10/2000 – 4:00 PM ET
Nervous is just what many of us are with the Dow having just brushed its first official bear market level since the gulf war. Obviously, options offer one avenue to insure against risk, but this raises several questions. What strategy should I use? And, with what options? This week, we will go over a few ways to hedge your portfolio. The simplest way to hedge is to buy at-the-money puts against your underlying stocks. Here you pay the maximum time premium for full coverage if the stock falls, while still having full participation in gains if the stock rises (minus, of course, the premium). A strategy that offers a higher return if stocks rise is buying out-of-the-money puts. Where you place the strike represents the "deductible" on your insurance (i.e., how much loss you can stand before your insurance kicks in). Simply find a level of risk you feel comfortable with and buy puts at that level. One problem with this strategy is that out-of-the-money options tend to be overpriced due to almost universal demand for nominally "cheap" insurance. Perhaps the cheapest form of portfolio insurance is the purchase of index puts. However, there are some problems with index options. For instance, your portfolio and the index may have very low correlation. In addition, out-the-money index puts, while nominally inexpensive, are often theoretically overpriced, again because of the demand for cheap insurance. Still, index puts can insure you against the risk that the overall market will decline. Before hedging with index options you should take a good look at your portfolio to see which index it would really cover the risk. For instance, the S&P 500 is still only around 35% in technology. If your portfolio is heavily in tech, then you should look more at Nasdaq index options. Then there is still the question of purchasing shorter-term or longer-term options. Recently investors have favored shorter-term options despite the fact that they are more expensive to hold (i.e decay faster) than longer-term options. The trend towards buying shorter-term index options tells us a lot about current investor psychology. Longer-term, their view of the market is still bullish; therefore (goes the logic), it makes little sense to buy longer-term puts that will only expire worthless. Instead, insure shorter-term risk with shorter-term insurance. What you need to ascertain is that your short-term insurance really gives you a payback if what you expect actually occurs. A put that that is struck 10% out-of-the-money will have no payoff if the market ends up down 10% on that option expiration date. As of Thursday March 9th, our model was recommending more than 35 index options for put buying and equity puts on more than 30 stocks including Coca-Cola, Dell and Philip Morris. Call buying was recommended on options on more than 30 underlying stocks including AES, Lycos and Nokia. If you would like to find out more about the Value Line Daily Options Survey click here. If you would like to see a copy of our track record: If you have any questions click here. Lance R. Ettus
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