Institutions and mutual funds are the biggest customers for index options.  They manage large diversified stock portfolios, and it is easier for them to purchase puts on an index or sector rather than purchasing them on hundreds of individual stocks.  When analyzing how to hedge their risk, they must balance the cost of the strategy against their opinion of the market. 

Index puts are not cheap, so why are these managers willing to risk underperforming the market by 3% during a 90-day period (approximately a 13.2% annual rate)?  The manager is willing to take that risk if he or she has a bearish view, and hopes to beat the market by profiting from the puts.  The objective of the index option purchase is to limit or insure against portfolio losses.

The technique of hedging your portfolio is straightforward.  Find the index with the composition that most closely resembles your own portfolio, and then purchase out-of-the-money protective puts.  But unlike stock options, where you know you need to purchase one put for every 100 shares of stock you own, your portfolio is unlikely to have precisely the same stocks as the index, and not in exactly the same proportion. 

There are measures such as portfolio delta that allow you to come close, but hedging a portfolio is still a bit of an art.  Don’t spend too much time worrying if you have exactly the right amount to cover your portfolio.  The match might not be exact, but the strategy has a specific purpose: to anticipate and protect against broad declines of the type we have all seen in recent years.  Any hedging at all will help if the market does drop, offsetting at least part of your losses. 

The unusual part of this strategy is your objective: purchase puts, and then hope they expire worthless!  Strange as it may sound, a portfolio manager actually hopes that his out-of-the-money put options expire worthless.  After all, an honest homeowner does not hope that his house burns down so that the insurance policy will pay off.  Similarly, a portfolio manager who buys out-of-the-money puts doesn’t hope the market declines so that his portfolio will decrease in value by less than the overall market. 

This is a hard concept for many investors to understand.  But an experienced money manager recognizes there are times when a sharp market correction, while not expected, has a high enough probability of occurring to justify the expenditure of 1 to 3% of the portfolio on out-of-the-money puts for 1 to 3 months of insurance.

You can also use index options to insure other positions, to a degree.  For example, if you have invested part of your portfolio in shares of a mutual fund, you could buy index option puts to protect your shares in the event of downturn in overall value.  This assumes the index you select approximates the equity holdings of the mutual fund.   and that (b) you believe the market is heading upward, but you recognize the possibility that your timing is off. 

Stocks do tend to move generally in the same direction as the overall market.  That means that stocks – even those whose individual fundamentals are strong – tend to decline when the overall market does.  By the same argument, a strong bull market tends to pull most stocks in an upward direction, including under-performers, at least to some extent.  Index options allow you to preserve your capital by insuring your holdings against a market downturn.