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Using a simple three-step process and LEAPS options, longer-term investors can limit downside risk while still capitalizing on unlimited upside potential if the underlying equity appreciates in the short term.

The majority of traders and investors place long-only equity trades in index and mutual funds within retirement accounts. Unfortunately, this majority is forgoing a key advantage of active trading and non-equity financial instruments: the ability to hedge. While hedging may sound like a complicated strategy, index LEAPS (long-term equity appreciation securities) can make the process very easy for the average investor to mitigate portfolio risk.

Motivations for Hedging a Portfolio

Since most investors are saving for retirement, they often prescribe to the "buy-and-hold" mentality using a combination of index and mutual funds. Unfortunately, this methodology means always being fully invested in a market that can move to the downside at inopportune times. Luckily, index LEAPS can be used to help limit the potential downside, while preserving all of the upside.

Why use index LEAPS to hedge against potential downside? Suppose that the S&P 500 has recently moved off of its low with a strong, fundamentally driven rally, but you suspect that any new interest rate decisions could put the market at risk. While you believe the S&P 500 will move higher in the long-term, you are worried about a short-term rate hike, so you may decide to use index LEAPS to limit your risk.

See related: LEAPS: Better Odds, Less Time Decay

But why not simply buy and sell the mutual funds instead? For one, some "load" mutual funds charge hefty fees for such transactions, while transaction costs from brokers can also quickly add up. Moreover, investors hoping to rapidly sell a mutual fund when an adverse event occurs will also find that the value of their holdings are calculated at the end of the day—so they will incur the loss anyway.

Hedging Your Portfolio with LEAPS

The most common LEAPS index hedging strategy involves purchasing one index LEAPS protective put that correlates to each index or mutual fund holding in a portfolio. While this may seem pretty straightforward, there are three key steps to consider when executing the strategy.

NEXT: Step 1: Formulate an Outlook