Options are a powerful tool for protecting your portfolio in falling markets. Option trading can provide some protection for your portfolio in times of market volatility. By employing an option strategy, you can lock in profits or limit losses in case the market falls, providing some stability to your investment.

In this article, we will understand the basics of options, its types and how to protect your portfolio when the markets go down.

What Are Options?

Options are financial contracts that give the option buyer the right, but not the obligation, to purchase (or sell) an underlying asset at a set price or within a certain time period. Options can be used to hedge against risks or to speculate on future prices of the underlying assets on which they are based.

The underlying assets can be stocks, indices, commodities, interest rates, currency pairs, etc.

Buying a Call option gives you the right to buy a stock at a set price and can be sold by the owner of the option before it expires. Selling a call option gives you an obligation to sell a stock at a set price when the right to buy is exercised by the owner of the option before it expires.

In today’s market conditions, many individual investors may feel the need to protect their portfolios by taking option positions. There are a number of different option strategies that can be used for this purpose, and each has its own advantages and disadvantages.

Types Of Options:

Options are mainly of two types: Call and Put.

Call options give the holder the right, but not the obligation, to buy an asset at a set price before a set date. Put options give the holder the right, but not the obligation, to sell an asset at a set price before a set date. Like everything, every Option has its own unique benefits and drawbacks.

The strategy we will discuss today involves buying put options as a type of insurance against your portfolio.

One word of caution here: since there are so many different options strategies that investors can use; it may often become confusing for beginners. So, make sure that you take help from an expert to determine which option strategy might be most appropriate for you.

Read Also: Introduction to Stock Market Index

How to hedge a portfolio by buying Put Options?

A Put Option is a financial instrument that allows the buyer to sell a security with the expectation of buying it back at a lower price within a set time frame. This can be used to hedge against risks in one’s portfolio or as protection in case of an unfavourable trend.

Buying Put options can be advantageous if the investor believes that the underlying security will decline in value and want to protect their investment while still benefiting from any potential gain.

Let us understand this with an example.

Ramesh is expecting the market to fall and wants to protect his investment in a company called Alpha Ltd. To mitigate the possible loss, he decides to buy a put option based on the shares of Alpha Ltd that expires three months from today.

The strike price of the option is Rs250 per share, and the premium he pays for this option is Rs 5. The current share price is Rs.250 per share.

Since Put Options gain value when the market declines, this strategy executed by Ramesh is a Bearish strategy. He will benefit when the price falls.

In other words, when the price of Alpha Ltd shares will fall,

• The value of the shares he holds will fall, and
• The value of the Put Options he holds will go up.

Let us assume that within the next 3 months (i.e., within the validity of the Put options), the price of Alpha Ltd falls to Rs 225. At this point, he squares off the Put options.

The following will be his payoff:

• The value of the shares he holds falls from Rs 250 to Rs 225. So, the notional loss is Rs 25.
• The Put options will gain value since the market has fallen and the premium associated with the Put Options will go by approximately Rs 25.

Hence, by using Put options, Ramesh will be able to mitigate the possible losses on his portfolio.

Read Also: How Can you protect your portfolio from downwards falls?

What If the price of the share rises instead of falling?

In that case, Ramesh will not exercise the Put option and let it expire. He will then lose the premium paid by him, i.e., Rs 5.

How to calculate the number of lots of put options to be bought?

To execute the strategy mentioned above, the first thing you need to do is calculate the number of lots of Put options you will need. This in turn will depend upon how many shares of the company you are holding in your portfolio and the lot size of the option contract on that company.

Thereafter, you can use the following formula to find the number of lots to be purchased:

Number of lots = (Number of shares of the underlying in the portfolio/lot size)

For example, If Ramesh was holding 1500 shares and the lot size is 500, then he will need to buy:

(1500/500) shares, i.e., 3 lots.

What if the number of lots does not exactly match the number of shares held?

Say in the above example the number of shares held was 1600, and not 1500. How will you hedge in that case?

Since you will have to follow the lot size specified by the Stock Exchanges, you will still have to buy 3 lots. In that case, 1500 shares will be hedged, and the remaining 100 will remain unprotected.

Read Also: How to Build a Rs 100 Crore Portfolio In 20 Years

At Finideas, we use this strategy actively to protect the portfolios of our investors in the Index Long Term Strategy we have developed. Please get in touch with us to know how can we grow your portfolio steadily while taking very limited risks.

Happy Investing!

This article is for education purpose only. Kindly consult with your financial advisor before doing any kind of investment.