Using LEAPS as a Hedge

Warren Buffett recommends that individual investors purchase a basket of stocks and hold it over the long term. The legendary investor has rarely sold any of his holdings and managed to become one of the richest people in the world following this strategy. Unfortunately, many investors don’t have the patience or confidence that Mr. Buffett possesses.

One common strategy to hedge against a downturn in stocks is known as a protective put. This strategy works in such a way that as an index goes down, the value of the protective put increases, with profits on the options at least partially offsetting any losses seen in the value of the portfolio. The same concept can be applied to longer-term index put options – or LEAPS puts – to hedge an entire stock portfolio.

How It Works

Let’s suppose that an investor owns a diversified portfolio of stocks worth $100,000 and would like to cushion it against a market downturn. The investor could purchase 10 puts contracts on the Russell 2000 that cost $1,000 and amount to $50,000 in protection. If the market takes a turn for the worst, the $100,000 portfolio may be down, but the $50,000 in protection will have increased to offset the losses at least partially.

The magnitude of the protection depends on the strike price selected for the LEAPS put. Potential profits on the position can then be realized by either selling the option contracts or exercising them, and these gains are then used to offset the losses on the portfolio. The puts will limit the stock portfolio’s loss to a certain extent, while leaving the upside potential wide open. The breakeven point on the upside will then be the current portfolio value when insured plus the cost of the puts.

CBOE’s Example

The Chicago Board of Options Exchange provides a great example of such a trade on their website:

An investor has a portfolio of mixed stocks worth $2 million that closely matches the composition of index XYZ. With the current level of index XYZ at 100, this investor wants to buy XYZ puts to protect the portfolio from a market decline of 4% over the next 60 days. The investor might determine the number of puts to purchase by dividing the amount to be hedged (the $2,000,000 portfolio) by the current aggregate value of index XYZ (100 x 100 multiplier = 10,000). $2,000,000 ÷ 10,000 = 200, so the investor purchases 200 XYZ puts. This number of contracts should be adjusted according to the beta of the portfolio’s performance against XYZ if it does not track the underlying index exactly.

To establish the protective put position with the downside protection needed the investor chooses an XYZ put strike price 4% below the current XYZ level of 100, or the 60-day XYZ 96 put. The XYZ 96 puts are purchased for a quoted price of $0.75, or $75 per option. 200 puts are therefore bought for a total of $75 x 200 contracts = $15,000.

Types of LEAPS Puts

Choosing the right type of LEAPS put to purchase is critical to the success of a hedging strategy. The investor’s portfolio must track exactly, or at a consistent ratio or beta, to the performance of an index that underlying a class of index options. These indexes can be sector-specific or broad market, depending on the composition of the investor’s portfolio.

Here are the most common indexes:

DIA - DIAMONDS®
DJX - Options on the DJIA
DXL - Jumbo DJX
EFA - Options on iShares® MSCI EAFE® Exchange Traded Fund
IWF - iShares® Russell 1000® Growth Index Fund
IWM - iShares® Russell 2000® Index Fund
IWN - iShares® Russell 2000® Value Index Fund
MDY - Standard & Poor’s MidCap 400® Index
MNX - CBOE Mini-NDX
NDX - CBOE Nasdaq 100 Index
OEF - iShares® S&P 100 Index Fund
OEX - S&P 100 Index-American
QQQQ - Nasdaq 100 Index Tracking Stock
RUT - Russell 2000® Long-Term Index
SPY - SPDR Options
TLT - iShares® Lehman 20+ Year Treasury Bond Fund
XEO - S&P 100 Index-European
XLE - Energy Select Sector SPDR
XSP - Mini-SPX
XLU - Utilities Select Sector SPDR

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