Investing

In the following examples, we will look at using index options to hedge an equity portfolio against market losses.  Although the following examples are focused at the portfolio level, these strategies could just as easily be used to hedge individual portfolio holdings against losses by using options on individual stocks.

Photo by Luis Villa del Campo (CC by 2.0)

We will look at three scenarios; a 5% market decline, a 15% market decline and a market rise of 5%.  In all three examples we will examine the number of contracts needed to fully hedge an equity portfolio using the money options and the resulting gain or loss for the portfolio.  Any gains realized because of employing these strategies in a down market act as portfolio insurance for which the investor has paid a premium in the form of the cost of the option.

Example

Mr. Jones holds a portfolio of individual securities.  The portfolio is equally weighted and highly correlated to the S&P 500 Index and has a total value of roughly $100,000.  Mr. Jones is concerned that the stock market will remain volatile and wants to hedge his portfolio against further losses.

Mr. Jones can purchase a protective index put on the S&P 500 Index to protect his portfolio from further market declines.

Let’s say that, currently, options on the S&P 500 Index are treading with a strike price of $78 and each option has a face value equal to $100.  Thus, Mr. Jones would need to purchase 13 S&P 500 puts to fully hedge a $100,000 portfolio against additional market losses ($100,000/$78/$100 = 12.8).  Three-month puts with a strike price of $78.00 are currently quoted at 2-5/8.  Therefore, the total cost of fully hedging the portfolio is $3,412.50 (2-5/8 x 13 x $100).

Scenario #1 – A 5% Market Decline

Let us assume that Mr. Jones’ instincts were correct and the S&P 500 declined by 5% since the time he initiated the hedge.  In this case, the settlement value (option price) has declined to $74.10, and the value of the long portion of the portfolio has fallen to $95,000.  The gain realized on the put options 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], generating a small profit for the portfolio.

Scenario #2 – A 15% Market Decline

In the “bear case”, the market has fallen by 15% since the hedge was put on and the settlement value of the index option is now $66.30.  Meanwhile, the value of the 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 = $15,120].

Scenario #3 – A 5% Market Gain

In this case, Mr. Jones’ assumptions about the direction of the market were incorrect.  The index put option has no value at expiration.  The impact on the portfolio is that the increase in portfolio value ($5,000) is reduced by the insurance premium (cost) of the put option ($3,412.50).  It should be noted that the protective put strategy does not necessarily eliminate gains in an up market.  They are simply reduced by the cost of the option.

Keep in mind that these examples assume there was a perfectly negative correlation between the index options and the stock portfolio.  Unless the long portion of the portfolio is represented by an S&P 500 Index mutual fund, this will rarely, if ever, be the case.  In practice, the offsetting gains attributable to the puts will be more or less than the paper loss on the long portion of the portfolio.

Advantage and Disadvantages of Protective Put Strategies

As with any form of portfolio insurance, a protective put strategy will be the appropriate form of portfolio insurance for some and not for others.  In general a protective put strategy is appropriate for investors who:

• Currently own a portfolio of securities, but do not want to sell because they believe the outlook for the underlying portfolio holdings is positive.
• Are looking for an inexpensive form of portfolio insurance.  Protective put strategy costs are limited to the option premium itself.
• Own or are considering purchasing a security but are concerned with potential downside risk.
• Own a portfolio of mutual funds and is looking to minimize equity market risk.
• Want to fully participate in market rallies after recovery of the option premium.

One major drawback to protective put strategies is that they expire.  As such, they represent an insurance policy that is in place only for a specified period of time.  If an investor wants to hedge an equity-oriented portfolio for a more extended downturn, for example one greater than a year, protective put strategies may not represent the best option, as they must be continually rolled over if the insurance policy is to remain in effect.  Similarly, if one is looking to permanently reduce equity risk in a portfolio, a longer-term strategy of reducing equity exposure by selling common stocks or increasing exposure to non-correlated asset classes may be more appropriate.

Although option strategies are not suitable for all investors, protective put strategies may provide the protection needed to invest in individual stocks during times of volatile markets.  Protective puts can limit downside risk.  Like all investments you must not rely on past performance to predict future results.  Consult with your financial advisor for risks and fees when purchasing any investment and be sure you stay properly diversified.