How Many Puts to Buy to Hedge a Portfolio

Most investors, especially those who dabble in options, understand the basic concept of a put option—a contract that gives you the right to sell a stock at a predetermined price. But when it comes to hedging, the real trick is balancing protection with cost efficiency. How many puts should you buy to hedge a portfolio effectively without burning through your returns?

The most effective hedging starts with understanding the volatility of your portfolio and how much downside risk you're willing to accept. Let’s dive into the math. Don't worry—I'll keep it simple, practical, and grounded in the realities of how the market operates, instead of inundating you with complicated formulas.

Step 1: Assess Portfolio Beta

Before you even think about how many puts to buy, you need to know your portfolio’s beta. Why? Because beta measures how your portfolio moves relative to the overall market. A portfolio with a beta of 1.0 moves in lockstep with the market, while a beta of 1.5 means it’s 50% more volatile than the market.

Here’s a quick example:

• Portfolio Value: $100,000
• Market Index Beta: 1.0
• Your Portfolio Beta: 1.2

In this case, your portfolio is 20% more volatile than the market, meaning a 10% drop in the market would likely lead to a 12% loss for you.

Step 2: Choose the Right Strike Price

This is the part where most people get stuck. How far "out of the money" should your puts be? Buying deep-in-the-money puts might seem appealing, but they come at a hefty price. Instead, a slightly out-of-the-money put gives you a more affordable form of insurance.

For instance, if the current market price of the stock in your portfolio is $100, you might choose a put with a strike price of $90. This way, you’re protected from significant market declines but not overpaying for unnecessary protection against minor price movements.

Step 3: Determine Portfolio Delta

The delta of a put option tells you how much the value of the option will move for every dollar change in the underlying asset. A put with a delta of -0.5 means that if the stock drops by $1, the value of the put increases by $0.50.

But how does this relate to your portfolio? Let's break it down:

• If your portfolio has a value of $100,000 and your beta-adjusted portfolio exposure to the market is $120,000 (due to the portfolio’s beta of 1.2), then you would need puts that hedge against $120,000 worth of exposure.
• If each put option has a delta of -0.5, one option would hedge approximately $200 worth of portfolio value (since $200 * -0.5 = -$100 of exposure reduction).

Step 4: Calculate the Number of Puts

Here’s where it all comes together. Using the example above, if you have $120,000 of market exposure and each put option hedges $200 of that exposure, you would need to buy approximately 600 puts to fully hedge your portfolio.

Formula:

$\text{Number of Puts}=\frac{\text{Beta-Adjusted Portfolio Value}}{\text{Hedge per Option}}$Number of Puts=Hedge per OptionBeta-Adjusted Portfolio Value​

In this case:

$\text{Number of Puts}=\frac{120,000}{200}=600$Number of Puts=200120,000​=600

But wait—are you really going to hedge 100% of your portfolio? Probably not. Hedging is often about managing risk, not eliminating it. You might decide to hedge only 50% of your portfolio, which would reduce the number of puts you need to 300.

Step 5: Consider Time to Expiration

Here’s a key point that often gets overlooked. The expiration date of your puts matters—a lot. Short-term puts provide cheaper protection but require constant monitoring and rolling over as they approach expiration. Longer-term puts, while more expensive upfront, provide peace of mind over a more extended period, which might be worth the additional cost.

For example, if you’re hedging against a potential market downturn over the next year, you’d likely look at LEAPS (Long-term Equity Anticipation Securities), which expire in 12 months or more. On the flip side, if you’re only worried about short-term market volatility, a 1-month put might be all you need.

Step 6: Analyze Cost vs. Benefit

You might be wondering, "Isn’t buying all these puts going to eat into my returns?" Yes, it can—if you’re not strategic about it. This is why it’s crucial to strike a balance between protection and cost. Instead of hedging 100% of your portfolio, you might hedge just a portion—say, 30-50%. This reduces your overall cost while still providing significant protection against a major downturn.

Let’s put this into perspective with a quick example:

• Portfolio value: $100,000
• Cost of hedging 100% of portfolio (600 puts): $6,000
• Cost of hedging 50% of portfolio (300 puts): $3,000

Now, imagine the market drops by 20%. Without any hedge, your $100,000 portfolio would lose $20,000. With a 50% hedge, your losses would be capped at $10,000. That’s a $7,000 reduction in loss (after accounting for the $3,000 spent on the hedge).

Step 7: Stay Flexible

The market changes, and so should your hedging strategy. There’s no one-size-fits-all answer to the question of how many puts to buy because it depends on the specific risks you’re facing at any given time. In some market environments, you might want more protection; in others, less.

Regularly review your portfolio, your risk tolerance, and the market conditions to ensure your hedging strategy stays aligned with your goals. Flexibility and adaptability are key to successful long-term investing.

Conclusion

So, how many puts should you buy to hedge your portfolio? The answer depends on your portfolio’s beta, your market exposure, the delta of the puts, and how much of your portfolio you actually want to hedge. It’s not about buying a one-size-fits-all insurance policy but about tailoring protection to fit your specific needs.

The key takeaway: Keep it simple, efficient, and cost-effective. Buying puts is about mitigating risk, not eliminating it. With the right approach, you can shield your portfolio from significant market downturns while still preserving the potential for future growth.