Purchasing stock index put options permits a portfolio manager to hedge equity market risk by limiting downside risk while retaining upside potential.
The examples that follow are based on hypothetical situations and should only be considered as examples of potential trading strategies. For the sake of simplicity, taxes, commission costs and other transactions costs, as well as tracking error, have been omitted from the examples that follow.
As a simple hypothetical, assume Fund Xs portfolio roughly matches the composition of the Standard & Poors 500 Stock Index(SPX) and that the SPX currently is at a level of 900.
Xs portfolio manager wants to establish a hedge to protect $90 million of the funds value. Assume that the fund manager determines the number of put option contracts to purchase by dividing the amount to be hedged ($90,000,000) by the current aggregate SPX value (900 x $100 or 90,000), i.e. 90,000,000/90,000 = 1,000.
If the premium for an SPX put with a 900 strike price and 30 days until expiration is quoted at a price of 20, the total amount required for the purchase is $2,000,000 (1,000 contracts x 20 premium x $100 multiplier).
Returns for the protective put position under differing market conditions at expiration