Today's Questions
Vic from Iowa asks:
I maintain a fairly large stock portfolio.Is there a way to lessen my risk using the S&P 500?
Vic, it is quite common for investors to "crash proof" their stock portfolios using S&P 500 futures or options, or a combination of both. It would make sense to do this if your portfolio was well diversified or in different sectors. Considering the way you phrased your question, I'm going to assume that you're well diversified and I will refer to the S&P 500 futures contract traded on the CME.
One way of providing protection for a stock portfolio on the decline, or expected to decline, would be to purchase S&P 500 puts. This would be analogous to purchasing an insurance policy for the value of the portfolio from an insurance company. The option has a face amount, or the amount of protection you want, a premium that pays for the coverage, coverage that you hope you never have to use by the way, and the policy period or amount of time the coverage lasts.
Each S&P 500 futures point is worth $250.00. So if the S&P 500 is trading at 1200, one futures contract is worth 1200 x $250 or $300,00. That means if you purchase 1 S&P 500 put contract you would have the right to go short the S&P 500 at the strike price you selected. Option contracts are available for every month of the year, so you can buy protection for 1month, 1year, or as many months or years as you want.
As an example, if your portfolio is worth $200,000 you could purchase 1 March, 2006, 1200 put. The put would cost you approximately 38 points based on current market conditions. If you are bracing for a considerable market correction in the first quarter this would give you dollar for dollar protection minus the premium you pay for the put excluding any fees or commissions. To put this in perspective lets look at what happened during our tech bubble burst in 2002. On March 20, 2002 the market opened at 1174.10, by July 24 the market closed at 844 before it started making its long climb back to where we are now. That's a drop of 330 S&P 500 points or $82,500 loss. If something like that
happened now, and the market dropped 330 points, that would put it around 870. Since the strike is 1200 and the market is at 870 the intrinsic value alone would be 330 points or $82,500. The profit on the put would be $82,500 minus the $9,500 premium and any fees and commission. A definite way to hedge against disaster.
Another way to trade is to receive a steady source of income using call spreads. By selling either monthly or quarterly call spreads 10% to 20% out of the money an investor could receive a steady stream of income against his stock portfolio. If you have a $500,000 portfolio that is representative of the S&P 500 and the market goes up 20% logically your value should increase approximately $100,000. This would more than offset any loss in your call spreads. Whether the market collapses, remains the same or explodes you will still maintain your stream of collected premium.
In the case of hedging or lessening risk in an overall portfolio, obviously strategy must be developed on a case-by-case basis tailored to the individuals needs.
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