Strategies > Buy Index Puts to Hedge the Value of a Portfolio
In this example, we assume that the portfolio contains an equal number of shares of each of the YZX Index stocks in order for the puts to exactly offset the loss on the portfolio. To the extent that the portfolio differs in composition from the index, the hedge will not be exact. You can undertake the same type of strategy to protect profits on mutual funds as well. However, your mutual fund holdings must "track" YZX for this strategy to be effective.
Assume YZX Index is at 78.00 and you hold a stock portfolio valued at about $100,000 that tracks the index. You have acquired shares over the last 10 years and accrued tremendous capital gains. You're several years away from retirement and don't want to withdraw funds prior to age 65. Still, you're concerned that the market may retreat over the next few months, affecting your ability to achieve retirement objectives.
You may purchase puts that can act as a type of "insurance policy" against a drop in the value of your portfolio. If YZX Index should fall, the profits on the put options position can offset the loss on the actual stock holdings. In this example, where the YZX index option multiplier is set at $100, you would need to purchase 13 YZX puts (100,000 / 7,800 = 12.8 or 13) to protect your stock portfolio. Three-month puts with a strike price of 78.00 may be quoted at 2-5/8. So the total cost of this level of portfolio protection is $3,412.50 (2-5/8 x 13 x $100). It should be noted that you can purchase put protection with a different "deductible" by choosing puts with different strike prices at a higher or lower cost. A scenario in which YZX falls is presented in the chart below.
Outcome 1: YZX fell by 5 percent.
>The YZX settlement value is 74.10, and the value of your stock portfolio has fallen by $5,000 to $95,000. The value of your options position at expiration almost exactly offsets the stock loss, as the puts can be exercised for $5,070 [(78.00 - 74.10) x 13 x $100 = $5,070].
Outcome 2: YZX fell by 15 percent.
The YZX settlement value is 66.30, and the value of your stock portfolio has fallen by $15,000 to $85,000. The value of the options position at expiration again almost exactly offsets the stock loss, as the puts can be exercised for $15,210 [(78.00 - 66.30) x 13 x $100 = $15,210].
Outcome 3: YZX rose by 5 percent.
Your anticipated market correction did not materialize. The gain in your portfolio is reduced by the cost of the "insurance" you purchased ($3,412.50).
Buy Puts to Hedge a Portfolio - Summary
Possible outcomes of investing in 13 YZX 78.00 puts to hedge a $100,000 portfolio
LEVEL OF YZX at expiration:
62.40
66.30
74.10
78.00
81.90
89.70
93.60
Move in the YZX Index
-20%
-15%
-5%
0%
5%
15%
20%
Change in value of stock portfolio
-20,000.00
-15,000.00
-5,000.00
0.00
5,000.00
15,000.00
20,000.00
Value of puts at expiration
20,280.00
15,210.00
5,070.00
0.00
0.00
0.00
0.00
* Exclusive of commissions & taxes
Basics of purchasing puts as portfolio protection
Profit & loss characteristics:
In a rising market the profit potential is unlimited; but, any gain is reduced by the premium paid for the puts. With a market downturn, losses (not including the cost of the puts) in the portfolio of stocks may be offset by an increase in the value of the put options.
Break-even point:
The break-even point is the initial value of the portfolio plus the premium paid for the put options. A higher portfolio value will generate overall profits for the investor, while a lower portfolio value will incur losses.
Time decay:
Over the duration of the index puts' lifetime, the time value portion of the premium will erode (i.e., decay), hurting the holder. At expiration, the puts' value will equal their intrinsic value.
Volatility:
An increase in volatility usually increases the value of the options, while a decrease in volatility usually decreases the value of the options.
CONCLUSION:
No matter how far YZX falls below 75.37 (78.00 - 2-5/8 = 75.37), the value of the options position at expiration will approximate the loss in the stock portfolio. However, it is important to note that although there is a large profit on the options position, there is still a net loss on the hedged position as a result of the cost of the put "insurance." In Outcome 2 above, the net loss is $3,202.50 ($15,210 - $15,000 - $3,412.50 = $3,202.50). If YZX remains flat or rises, the put options would have no value at expiration and you would lose the entire "insurance" premium of $3,412.50.
Buy Index Calls to Participate in Market Advances.
Assumption: The YZX index is at 78
You believe YZX will rise between 5 and 10 percent in the next quarter. A three-month 78.00 strike call option is trading for 3-1/8. You may purchase two of these at-the-money calls for a total price of $625 (3.125 x 2 x $100 = $625). You risk the entire $625 if YZX does not climb above the 78 mark at the end of the three months. Outlined in the chart below are several scenarios at the end of the three months.
Outcome 1: YZX rose by 10 percent.
Your forecast was realized, and the YZX settlement value was calculated as 85.80 on the day before expiration. You can exercise your call and receive the in-the-money amount of $7.80 (85.80 - 78.00 = $7.80) per contract for a total of $1,560 ($7.80 x 2 x $100 = $1,560). Your profit is $935 ($1,560 - $625 = $935).
Outcome 2: YZX rose by 2.5 percent.
You were correct in direction but wrong in magnitude. The YZX settlement value at expiration is calculated as 79.95. The call buyer can exercise and receive an in-the-money amount of $1.95 (79.95 - 78.00 = $1.95) per contract, for a total of $390 ($1.95 x 2 x $100 = $390). Although the call ends up in-the-money, there is a net loss of $235 ($625 - $390 = $235) on the investment because the in-the-money amount is less than the price paid. For these calls to break even, YZX would have to move approximately 4 percent to a level of 81.125. The break-even is calculated as the strike price plus the premium paid [(78.00 + 3.125) x 100 = 8,112.50].
Outcome 3: YZX remained at or below 78.
You were incorrect in the timing and direction of your forecast, and the market has not risen above the strike price level. In this case, you lose the entire call option investment of $625. This is the maximum you can lose, no matter how far YZX falls.
Buy YZX Call Strategy - Summary
Possible outcomes of investing in two YZX 78.00 calls at a premium of 3-1/8
LEVEL OF YZX at expiration:
70.2
74.1
76.05
78
79.95
81.9
85.8
Move in the YZX Index
-10%
-5%
-2.50%
0%
2.50%
5%
10%
Expiration value of two 78.00 calls
0.00
0.00
0.00
0.00
390.00
780.00
1,560.00
Less: premium paid (2 calls @ 3-1/8)
-625.00
-625.00
-625.00
-625.00
-625.00
-625.00
-625.00
Net gain/loss*
-625.00
-625.00
-625.00
-625.00
-235.00
155.00
935.00
* Exclusive of commissions and taxes
Basics of Call Purchase
Profit & loss characteristics:
Profit potential will be theoretically unlimited. The loss potential is limited to the premium paid for the call.
Break-even point:
The break-even point is an index level equal to the strike price of the call plus the premium paid for the call. An index level higher than that will be profitable, while a lower level will be unprofitable.
Time decay:
As time passes, the time value portion of the premium will erode. At expiration, the call's value will equal its intrinsic value.
Volatility:
An increase in volatility usually increases the time value portion of the option's premium. A decrease in volatility will usually hurt this type of position.
Buy Index Straddles in Anticipation of a Major Market Move
A variation combining the buy call and buy put strategies (discussed in the previous two examples) is called a "straddle" - it involves holding both a long call and a long put position with the same strike price and time to expiration. You might use this strategy if you believe that the market is poised for a major move but are unsure of the direction. Again, assume YZX is at 78. The Federal Reserve has indicated that it is strongly considering raising the Fed Funds rate to control inflation. Its decision, due in three weeks, will be influenced mainly by the consumer and producer price data due out in the interim. A jump in interest rates may send stocks sharply lower, while an announcement of steady inflation and interest rates may boost YZX to an all-time high. You expect that either of these outcomes could move the market by as much as 10 percent higher or lower in the next month.
A one-month 78.00 strike put option is trading for 1-1/2, and a one-month 78.00 strike call option is trading for 1-3/4. You may purchase five of each for a total price of $1,625 (1-1/2 x 5 x $100 + 1-3/4 x 5 x $100). You risk the entire amount if YZX does not make a major move in the next month. The table below shows several profit and loss scenarios based on the settlement value of YZX at expiration.
Outcome 1: YZX rose by 10 percent.
First, let's examine the case where the market rallies and the settlement value is calculated as 85.80 on the day before expiration. Here the profit on the call position is $3,025 [(85.80 - 78.00 - 1-3/4) x 5 x $100]. Since the puts expire with no value, the investor loses the $750 premium. Thus, the net profit on the combined position is $2,275 ($3,025 - $750).
Outcome 2: YZX fell by 10 percent.
Alternatively, consider the case where the market drops and the settlement value is 70.20 on the day before expiration. In this case, the puts end up in-the-money for a profit of $3,150 [(78.00 - 70.20 - 1-1/2) x 5 x $100], but the calls expire with no value for a loss of the $875 premium. Like the previous scenario where YZX rose 10 percent, the net profit on the combined position is $2,275 ($3,150 - $875). With a straddle purchase, your potential for profit is substantial and depends only on the size of YZX's move, not the direction.
Outcome 3: YZX remained at 78.
The worst-case scenario is that you were wrong and the YZX index did not move at all by expiration. Your potential for loss is limited to the amount of the premium paid for the five straddles, or $1,625. To be profitable at expiration, YZX would have to be below 74.75 or above 81.25 at expiration.
Possible outcomes of investing in five YZX 78.00 puts and five YZX 78.00 calls
Buy YZX Straddle Strategy - Summary
Possible outcomes of investing in five YZX 78.00 puts and five YZX 78.00 calls
LEVEL OF YZX at expiration:
70.20
74.10
76.05
78.00
79.95
81.90
85.80
Move in the YZX Index
-10.0%
-5.0%
-2.5%
0.0%
2.5%
5.0%
10.0%
Profit/Loss: long put*
3,150.00
1,200.00
225.00
-750.00
-750.00
-750.00
-750.00
Profit/Loss: long call*
-875.00
-875.00
-875.00
-875.00
100.00
1,075.00
3,025.00
Profit/Loss: combined*
2,275.00
325.00
-650.00
-1,625.00
-650.00
325.00
2,275.00
* Exclusive of commissions and taxes
Basics of straddle purchase
Profit & loss characteristics:
The maximum loss on a purchased straddle is limited to the premium paid for the straddle. Any move away from the strike price of the options begins to lessen the loss because one of the options will have value at expiration. The profit potential can be substantial.
Break-even point:
The break-even points of a straddle are the strike price plus or minus the total premium paid for the call and the put.
Time decay:
Over the duration of the straddle's lifetime, the time value of the call and put will erode, hurting the holder.
Volatility:
An increase in volatility usually increases the value of the straddle, while a decrease in volatility usually decreases the value of the option.
