Sharp swing in asset prices in recent times have made trading that much more difficult. Positions are stopped after which prices turn and often move in the direction of the original trade. Some traders use options to protect their portfolio. This week, we discuss whether index options are useful to protect the downside risk on your portfolio.
Protection or not
Futures price moves one-to-one with its underlying. Suppose you short index futures against your stock portfolio. The gains on your portfolio may be largely neutralised by the losses on the index futures. So, you cannot use index futures to protect the downside on your portfolio without hurting the portfolio’s upside potential.
If you want to keep your portfolio’s exposure to upside potential yet protect its downside risk, then you must consider index options. You have a choice of shorting out-of-the-money (OTM) calls or going long on OTM puts. Shorting OTM calls can only protect the downside risk on your portfolio to the extent of the option premium received. Note that shorting OTM calls also caps the portfolio’s upside potential.
What about long OTM puts? The issue is that it suffers from time decay; index puts will lose value with each passing day with losses accelerating as the option approaches expiry. So, buying OTM puts to protect the portfolio’s downside risk appears meaningful in two circumstances. One, you expect the portfolio to suffer adverse price movements well before the put’s expiry. This is important because the put will then not lose significantly from time decay (theta) and gain from downward move in the index. These gains from delta can reduce the unrealised losses on the portfolio. But the issue is that the put, being deep in-the-money, may not be easily tradable because it will carry large absolute premium. And two, the index declines sharply near or at option expiry. So, the put has large intrinsic value (despite losing time value) that covers the large unrealised losses on the portfolio. It is this argument that motivates some to buy farther-month OTM puts. The 25000 Nifty put December 2025 expiry traded for 343 points for a total cost of nearly ₹25,000 for one contract. Suffice it to know that you must buy delta-adjusted number of puts to protect your portfolio. The downside protection will be meaningful, but costly, if you expect the index to decline significantly below the breakeven point of 24567 (25000 less the option cost) at expiry. Note that you also have the choice of gradually liquidating your stock positions in the portfolio to moderate the risk of loss.
Optional reading
Active traders can trade against their portfolio to capture short-term price fluctuations shorting OTM index calls against the portfolio, not with an intent to protect the downside but to generate gains that can buffer unrealised future portfolio losses. This strategy can be implemented with weekly Nifty calls based on resistance levels closer to the current underlying price.
(The author offers training programmes for individuals to manage their personal investments)
Published on September 20, 2025
