HEDGING: HAVE UNDERLYING DUY PUTS
Owners of stocks or equity portfolios often experience discomfort about the overall stock market movement. As an owner of stocks or an equity portfolio, sometimes you may have a view that stock prices will fall in the near future. At other times you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy insurance using put options.
Index and stock options are a cheap and easily implementable way of seeking this insurance. The idea is simple. To protect the value of your portfolio from falling below a particular level, buy the right number of put options with the right strike price. If you are only concerned about the value of a particular stock that you hold, buy put options on that stock. If you are concerned about the overall portfolio, buy put options on the index. When the stock price falls your stock will lose value and the put options bought by you will gain, effectively ensuring that the total value of your stock plus put does not fall below a particular level. This level depends on the strike price of the stock options chosen by you. Similarly when the index falls, your portfolio will lose value and the put options bought by you will gain, effectively ensuring that the value of your portfolio does not fall below a particular level. This level depends on the strike price of the index options chosen by you.
Portfolio insurance using put options is of particular interest to mutual funds who already own well diversified portfolios. By buying Puts, the fund can limit its downside in case of a market fall.
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