Hedging with options — what insurance actually costs
The answer
A hedge is insurance on something you already own. The 3 standard structures are the protective put, which buys a floor under your holdings and costs a premium; the covered call, which sells your upside above a chosen price and pays you a premium; and the collar, which combines the 2 so the premium received pays for most of the protection. All 3 cost something. Insurance that costs nothing does not exist.
Why this costs you money
Two errors, and they are opposites.
Error 1 — buying protection permanently. An investor decides to protect their portfolio with put options, every month, forever. This feels responsible. It is also expensive: the premium is paid every month, and in most months the market does not fall enough for the put to be worth anything. Over years, a continuous protective put programme has historically cost more than the losses it prevented, for a portfolio that could simply have been held.
The reason is not mysterious. Put options are priced by people who have measured how often markets fall, and they charge accordingly, plus a margin. Buying that insurance continuously means paying that margin continuously.
Error 2 — the hedge that stopped being a hedge. An investor buys a put to protect a holding. The market falls, the put gains, and it feels excellent. So next time they buy more puts than the holding requires. Now, if the market falls, they make money overall. That is no longer insurance. A hedge larger than the underlying exposure is a speculative position wearing the word "hedge".
This is not a beginner's error. It is how China Aviation Oil lost $550 million in 2004 and how several airlines lost enormous sums in 2008. The transition is gradual and nobody announces it.
There is a third cost that is specific to individuals and it deserves its own sentence. Most retail investors do not need to hedge, because they can simply sell. A pension fund with a mandate to hold equities cannot sell. A promoter with a lock-in cannot sell. An index fund cannot sell. Those institutions hedge because selling is not available to them. An individual with a liquid portfolio and no obligations has an alternative that costs nothing: reduce the position.
If you are paying a premium every month to protect a portfolio you could have made smaller for free, you have bought a solution to a problem you do not have.
How it works
The protective put
You own the underlying. You buy a put with a strike below the current price.
- Below the strike, your losses stop. The put gains what the holding loses.
- Above the strike, you keep the gains, less the premium you paid.
- The premium is gone whatever happens.
The result is a floor. Your maximum loss becomes: (current price − strike) + premium, per unit held.
Choosing the strike is choosing your deductible. A strike close to the current price gives more protection and costs more. A strike far below gives less protection and costs less. It is exactly the same trade-off as an insurance excess on a motor policy, and the same rule applies: insure the outcome you cannot absorb, not the one that is merely unpleasant.
The covered call
You own the underlying. You write a call with a strike above the current price.
- You receive the premium immediately, whatever happens.
- If the underlying stays below the strike, you keep the premium and the holding.
- If the underlying rises above the strike, you must sell at the strike. You keep the premium and the gain up to the strike, and you give up everything above it.
This is not a hedge in the insurance sense. It provides only the premium as a cushion against a fall, which is small. What it does is convert an uncertain future gain into a certain present payment.
The cost is specific and it is the one people underestimate. You have sold the part of the distribution where the large returns live. Over long periods, a small number of very large upward moves account for a large share of equity returns. A covered call programme systematically sells exactly those.
The collar
Buy a protective put and write a covered call at the same time, on the same holding, for the same expiry.
- The premium received from the call pays for some or all of the put.
- You have a floor below and a ceiling above.
- If the 2 premiums are equal, the structure costs nothing in cash. This is called a zero-cost collar, and the name is misleading: it costs the upside above the ceiling.
The collar is the standard institutional answer for somebody who holds a large position they cannot or will not sell. A company founder, an executive with vested shares, a promoter under a lock-in restriction. They cannot sell, so they buy a floor and pay for it with a ceiling.
Sizing a hedge correctly
This is where most hedges go wrong, and it is arithmetic.
Number of contracts = (value to be hedged) ÷ (index level × contract multiplier)
If your portfolio is worth Rs 30,00,000, the index is at 24,000 and the lot size is 75, then 1 lot covers 24,000 × 75 = Rs 18,00,000. You need 30,00,000 ÷ 18,00,000 = 1.67 lots. You can buy 1 or 2. You cannot buy 1.67.
That is the Indian hedging problem in a single line. Lot sizes make precise hedging impossible for most retail portfolios. Buying 1 lot leaves you under-hedged. Buying 2 lots means you are over-hedged, which means the excess portion is a speculative short position, not insurance.
Then adjust for delta. A put with a delta of −0.30 provides only about 30% of the protection its notional suggests, for small moves. For a hedge intended to work in a large fall, this matters less, because delta rises toward 1 as the market falls. For a hedge intended to smooth small moves, it matters a great deal.
Basis risk
If you hold individual shares and hedge with index options, the hedge is not exact. Your portfolio and the index will not move together perfectly. That difference is called basis risk, and it is why an index hedge can fail to protect a concentrated holding. A portfolio of 5 mid-sized companies hedged with a large-cap index put may find the index falls 4% while the holdings fall 11%.
What it tells you, and what it does not
A hedge tells you what your worst case is. That is genuinely valuable, and it is the only thing a hedge reliably provides.
It does not tell you the hedge was worth buying. A hedge that expires unused was not a mistake; it was insurance that was not needed. The mistake is only visible across many periods, by comparing total premiums paid with total losses avoided.
And a hedge does not make a position safe. A hedged position is still a position. If the underlying holding was too large for your account before, it is too large now, with a monthly cost attached.
The decision rule
Hedge only when you cannot reduce the position, and only in the size the position actually requires.
Ask these 4 questions in order. The first one eliminates most hedges.
- Can I sell instead? If yes, and there is no tax, lock-in, mandate or
liquidity reason preventing it, selling is cheaper than any hedge. Do that.
- What specific event am I insuring against, and when does it end? A hedge
with an end date is insurance. A hedge with no end date is a permanent cost.
- What is the annual cost as a percentage of the portfolio? Compute it.
Compare it with the return you expect from the portfolio. If protection costs 3% a year and you expect 10%, you have given up 30% of your expected return.
- Is the hedge larger than the exposure? If yes, the excess is
speculation. Reduce it.
Try this now
Five minutes with your own portfolio value. Almost nobody has done this, and the number is usually a surprise.
- Open your holdings and write down the total current value of your equity portfolio.
- Open the index option chain for the next monthly expiry. Note the current index level and the lot size.
- Compute the notional value covered by 1 lot: index level × lot size.
- Compute how many lots you would need: portfolio value ÷ notional per lot. Write down the answer including the decimal.
- Find the put strike about 5% below the current index level. Note its premium.
- Compute the cost of the hedge: premium × lot size × number of lots needed.
- Express that as a percentage of your portfolio value.
- Multiply by 12. That is the approximate annual cost of holding that protection continuously.
What you should see. Three things, and each one settles a decision.
First, the number of lots in step 4 is almost certainly not a whole number. For most Indian retail portfolios it will be below 1, which means the smallest available hedge covers more than the portfolio is worth. You cannot hedge precisely. You can only over-hedge or under-hedge.
Second, the monthly cost in step 7 is larger than most people expect for a strike close enough to be useful, and the annualised figure in step 8 is often a meaningful fraction of a reasonable expected annual return.
Third, compare that annual cost with simply holding less. If protection costs a few percent a year, and moving 20% of the portfolio into cash or short-duration debt costs nothing, ask honestly which one solves your actual problem.
If you hold a single concentrated position, do the exercise again using options on that specific company if they exist. The cost is usually higher, and the number is the honest price of keeping a position you are afraid of.
Three real cases
1. Southwest Airlines, roughly 2000 to 2008 — a hedge that did its job The airline hedged a large proportion of its jet fuel consumption using derivatives, over multi-year horizons, at a time when many competitors did not. When crude oil prices rose sharply through the middle of that decade, Southwest's fuel costs were substantially lower than they would otherwise have been, and the company reported large hedging gains across several years. Two features made this a real hedge and not a bet. The quantity hedged was tied to fuel the airline would actually consume, and the position existed because the company genuinely carried the exposure. When oil prices collapsed in late 2008, the same programme produced losses. That is not a failure. A hedge that never costs anything was never a hedge.
2. Cathay Pacific Airways, 2008 — a hedge that became a position The airline held fuel hedging contracts that produced very large losses when fuel prices fell sharply in the second half of 2008, reported in its results for that year. The structures involved were not simple purchases of protection; they included written options which produced losses beyond the value of the fuel exposure being hedged. The lesson is the one from the "why this costs you money" section, at corporate scale: a hedging programme that includes written options can lose more than the exposure it was built to protect, and at that point it is no longer insurance.
3. Pershing Square Capital Management, March 2020 — the hedge that paid, once The fund bought credit protection in late February and early March 2020 as a hedge against its equity holdings, at a cost widely reported as roughly $27 million. As credit markets deteriorated the position gained enormously, and the fund exited it around 23 March 2020 for a reported figure in the region of $2.6 billion, using the proceeds to buy equities. Read this case carefully, because it is the one most likely to be misused. It is a single observation, taken by a professional with a specific view, over a period of weeks, using instruments an individual cannot access. The fund's manager has been explicit that the position was closed and not maintained. A hedge held permanently in the hope of one such outcome pays premiums for years, and the years are certain while the outcome is not.
The question that resolves it
A novice asks: how do I protect my portfolio?
An expert asks: why can I not simply own less of it?
Almost every retail hedging question dissolves under the second one. The institutions that hedge do so because selling is genuinely unavailable to them: a mandate, a lock-in, a liability to match, a tax consequence, or a position too large to exit without moving the price. If none of those apply to you, the hedge is a paid substitute for a free action.
What would make this wrong
If protective puts were free, permanent protection would be obviously correct. It is not free, and the accumulated cost is the whole argument.
Four honest limits.
There are real reasons an individual cannot sell. A large capital gain with a tax consequence. Employee shares under a lock-in. A promoter holding under regulatory restriction. A concentrated position in an illiquid company. In each of those cases hedging is the correct answer and this article's scepticism does not apply.
Event hedging is different from permanent hedging. Buying protection for a specific, dated, binary event — a court ruling, an election result, a scheduled policy decision — has a known start and end. The cost is bounded and the purpose is clear. The criticism here is aimed at continuous, undated protection.
Covered calls are not a hedge and this article's harsh framing may be unbalanced. For an investor who genuinely intends to sell at a particular price, writing a call at that price is a way of being paid to place the sell order. That is a coherent and sensible use, and it has its own article in this cluster.
Tail hedging can work for a portfolio that must survive. Strategies buying far out-of-the-money puts systematically have produced extraordinary returns in rare episodes and steady small losses otherwise. Whether the total is positive is genuinely contested, and it depends on the period measured.
In India
Protective puts on the Nifty 50 and other indices are liquid, particularly in the nearest monthly expiry. Single-stock options are available on a restricted list of companies and are much thinner.
Lot sizes make precise hedging impossible for most retail portfolios. SEBI's October 2024 measures raised the minimum contract value for index derivatives. A portfolio smaller than the notional value of 1 lot cannot be hedged at all without taking a short position larger than the holding.
Buying a put requires the premium upfront and no margin. Writing a call against a holding requires margin, even when the shares are held, unless the shares are pledged to the broker. This is a practical obstacle to covered call writing in India that does not exist in the same form in the United States.
Index options are European-style and cash-settled, so a protective put pays a cash difference at expiry rather than allowing you to deliver shares. Your shares remain yours; the hedge settles separately in cash. Single-stock options are physically settled.
Tax treatment differs between the hedge and the holding. Gains on exchange-traded derivatives are generally treated as business income, while gains on the shares are capital gains. The consequence is that a hedge which works economically may not offset neatly for tax, and this should be checked with a professional before building a programme.
Common Indian hedging occasions include the Union Budget, RBI monetary policy announcements and general election results. Implied volatility rises before each, which means the protection is at its most expensive exactly when people most want it.
In the United States
Index put protection is deep and liquid across many expiries, including long-dated contracts. An investor can buy protection for a year rather than rolling monthly, which reduces the number of transactions and the cumulative transaction cost.
Covered calls are the most widely used retail options strategy, supported by the lowest broker approval level. A holder of 100 shares can write 1 call against them with no additional margin, because the shares themselves are the collateral.
Collars are standard for concentrated positions. Executives and founders with large single-company holdings use them routinely, often alongside a prepaid variable forward.
Cboe publishes benchmark indices for these strategies, including a buy-write index and a put-protection index, with long histories. This is unusually good evidence: anybody can compare the long-run outcome of a systematic covered call or protective put programme with simply holding the index, without running the strategy themselves. India has no equivalent published benchmark with a comparable history.
American-style equity options add assignment risk to covered calls. A written call can be exercised early, particularly before an ex-dividend date, so the shares can be called away at a moment not of your choosing.
Where they differ, and what that tells you
Whether a retail portfolio can be hedged at all. In the United States, a $40,000 portfolio can be hedged with index put options in a size that approximately matches it, because contracts are on 100 shares of a moderately priced index product. In India, the minimum index derivative contract value means most retail portfolios are smaller than 1 lot. What that tells you is that hedging is a genuinely available tool for American retail investors and largely an institutional tool in India. An Indian reader of American hedging material is reading about something they cannot execute in the size described, and the usual consequence is an over-hedged portfolio that is now short the market.
Whether the evidence is available. Cboe's long-running benchmark indices let an American investor check the historical cost of these programmes directly. No comparable Indian series exists with the same history. The American investor can answer "does this work?" with data. The Indian investor has to reason from the mechanism. That is a reason to be more cautious in India, not less.
Whether covered calls are practical. The American structure — 100 shares collateralise 1 call, no additional margin — makes covered call writing simple. The Indian structure requires pledging shares to obtain margin benefit, which is an extra process with its own costs and haircuts. The strategy exists in both markets. In one of them it is a 2-click operation and in the other it is a project.
Carry this
- A hedge is insurance on something you already own. It always costs something.
- Protective put: a floor, paid for with premium. Covered call: a ceiling, paid for you. Collar: both.
- Size the hedge to the exposure. Anything larger is speculation with a respectable name.
- Compute the annual cost as a percentage of the portfolio before starting, not after.
- If you can sell instead, selling is free and a hedge is not.
Knowledge check
Related
- The covered call: getting paid to hold a stock you already own
- The protective put: buying insurance for a stock you own
- The collar: combining a covered call and a protective put
- Buying options compared with writing options
- Risk management and position sizing
- ← Options and derivatives