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There’s nothing like a 23 per cent fall in the sharemarket to focus investors’ minds on protecting their portfolio. Arguably, it’s a bit late to think about this now but for those who have used the slump to establish new shareholdings, the summer’s experience should have portfolio insurance high on the agenda.

You can get insurance for your share portfolio by buying put options over shares, which give you the right to sell shares for a higher price than you think the market price will be at exercise time. The put option acts as an insurance policy as it guarantees a minimum value for the underlying shares. If the share price rises above the strike price and stays there, your put option will expire worthless, but this means that you’re enjoying capital gain on the shares.

Buying put options gives you the right to ‘put’ your shares on to someone else – but that person will not want them if the share price is above the strike price, meaning that there’s no danger of losing your shares if things go wrong. You can keep this strategy going indefinitely by buying new puts.

Index warrants are also used for portfolio hedging. These warrants give you the right to sell the notional basket of shares that makes up the S&P/ASX 200 Index. Since an index doesn’t have a price, index warrants set an exercise level (point value of the index) rather than an exercise price.

Say the exercise level is 5500 points on the S&P/ASX 200: a call warrant will be in the money (it can be exercised now for a profit) if the index rises above this level, while a put warrant will be in the money if the index falls below 5500.

The put warrant rises in value when the market falls, compensating for the drop in value of your portfolio. The risk in this scenario is if the market rallies, and is trading above the warrant’s exercise level at expiry. In this case, you can lose the amount you paid for the warrant, but that’s the insurance cost, and your share portfolio benefits from the rise.

Index warrants are settled by cash. On exercise, the holder of an index put warrant will receive an amount of cash for the amount by which the index is below the exercise level.

Index put warrants come in two kinds: an index put exchange-traded option (ETO), created by the Australian Securities Exchange (ASX) and bought directly on the ASX; and ‘index warrants’ issued by investment banks (Macquarie Bank, Citigroup, UBS and ABN AMRO) and which are also traded on the ASX.

The former have set maturity dates and set strike prices (index levels). Liquidity is provided by market-makers (designated broking firms) who quote bid-offer spreads.

The bank-issued warrants differ mainly in that the issuer is regulated by the ASX to provide constant liquidity and ensure that fair bid-offer spreads are maintained. The issuer has flexibility in maturity dates and strike prices.

Pia Cooke, division director at Macquarie Equity Markets Group, says an investor wanting to protect a shareholding on the downside, and who thinks that the stock will not rise significantly over the short term, can lessen the cost of the protection by “wrapping a collar” around the stock, by buying a put option and selling a call option.

“The put gives you downside protection, but you’re also selling a call over the stock. Say the stock is at $10: you might buy a put at $9.50 and sell a call at $10.50. The sold call provides you with premium, which can offset the cost of protection almost to zero,” she says.

Investment banks will tailor a portfolio collar for sophisticated investors such as large shareholders or company executives, in an over-the-counter (OTC) transaction between the issuer and the holder of the stock. But Cooke says individual shareholders can put together their own collar in the ETO market by buying a put and selling a call over each of their main shareholdings.

Investors can also use contracts for difference (CFDs) – equity derivatives that represent a theoretical order to buy or sell a traded asset – to hedge individual stock positions or a share portfolio. If you believe a stock in their portfolio is going to fall – but you don’t want to sell it – you can ‘short’ it using CFDs. When the share price drops, even though the value of their holding falls, they make a profit on the CFDs and the two can offset each other.

Investors can also hedge their share positions using index CFDs, offered by CFD providers CityIndex, IG Markets, GFT, CommSec, First Prudential Markets and BrokerOne. The margin required is usually 1 per cent.

Some providers – for example and IG Markets – offer more flexibility through a wider range of index CFDs. For example, an investor can gain hedging more specific to their portfolio by using CFDs over the ASX 20 or any of the GICS sector indices. For example, a portfolio that is heavy in the big four banks could effectively be hedged using a CFD on the GICS Financials (S&P/ASX 200 Financials) index.

Put options, warrants and CFDs are all leveraged investments. CFD providers say that CFDs have three major advantages as hedging tools. The first is that whereas exchange-traded options (ETOs) have to be traded in 1000-lot parcels, using CFDs allows you to hedge the exact amount of shares you own, because CFDs have a one-for-one relationship with the stock. (But if using index CFDs to hedge a portfolio, an exact hedge will probably not be possible.)

Secondly, the holder of a short CFD is paid interest while the position is open – whereas the holder of a short position in ETOs effectively pays time decay for that position. Thirdly, there is no set expiry – the investor can put the hedge on for as long or as short as they like.