June 2nd, 2007 | 
Author: The risk involved in the stock market makes it necessary to find some way to insure your portfolio against the ever-present chance of high losses. For instance, if an investor holds shares of Company A, and he or she is worried about a possible crash, this person can insure that position by purchasing a put option. This technique is called hedging and is used to protect a stock, futures position or portfolio from an adverse change in the market. The question that arises is: How do you hedge a stock portfolio?
One way is to consider index options for hedging the risk in your portfolio. These options are available on an entire index, rather than an individual stock. Some options you may consider for hedging are the Nasdaq 100, the Dow Jones Industrial Average and the S&P 500.
You can go for perfect hedging, which as the name suggests removes all risk, and partial hedging which reduces risks to only a certain extent. However, you’ll need to analyse two key factors before you can start hedging your portfolio against a change in the market scenario.
First, you’ll need to find those indices that hold stocks similar to the ones in your portfolio. For example, if your portfolio consists mainly of stocks in the technology sector, then the hedging should be to minimise risk in your technology holdings. In this case you might want to take a look at the Nasdaq 100 for trading options. Secondly, you’ll need to identify the strike prices and expiration dates that coincide with your objectives.
Hedging is particularly useful if an investor has experienced an extended period of gains and feels that this increase might remain constant in the future. But again, like all option strategies, portfolio hedging requires a little planning. Though it may take up some effort in the investors part, the ‘insurance’ that hedging provides is more than worth the effort and time put in when stock prices are on the decline.
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