Protective Put Options

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 X’s portfolio roughly matches the composition of the Standard & Poor’s 500 Stock Index(SPX) and that the SPX currently is at a level of 900.

Fund X’s portfolio manager wants to establish a hedge to protect $90 million of the fund’s 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

Range of Market Outcomes S&P 500 Expiration Level Value of Unprotected Portfolio Profit/Loss Index Options Profit/Loss Protected Portfolio Value of Protected Portfolio
+ 15.0% 1,035.00 103,500,000 (2,000,000) 11,500,000 101,500,000
+ 7.5% 967.50 96,750,000 (2,000,000) 4,750,000 94,750,000
0.0% 900.00 90,000,000 (2,000,000) (2,000,000) 88,000,000
- 7.5% 832.50 83,250,000 4,750,000 (2,000,000) 88,000,000
- 15.0% 765.00 76,500,000 11,500,000 (2,000,000) 88,000,000

Possible Outcomes

The Index Rises – At expiration, the puts have no value. However, in exchange for the cost of the puts (an insurance expense to the portfolio), the fund manager achieved the goal of establishing a hedge for a portion of the portfolio and did not incur the expenses of converting that portion of the assets to cash. Also, note that the portfolio retains any dividends associated with holding the assets. Given the assumption of a correlation between the portfolio and the index, the value of the portfolio increases.

The Index Falls – If the puts are at-the-money or in-the-money, an increase in the value of the puts may approximate the loss in the portfolio’s value. Tracking error will undoubtedly have an effect on the actual losses in portfolio value if the composition of the portfolio does not match the composition of the index. However, the protective puts limit the portfolio’s downside, the portfolio retains any dividends associated with holding the assets. If the index falls but the puts remain out-of-the-money, the cost of the puts is an insurance expense to the portfolio.

The Index Remains Stable – The puts have little or no value at expiration, resulting in a loss of the premium, which can be considered an insurance expense to the portfolio. This expense is, at least partially, offset by any dividends associated with holding the assets. The value of the portfolio remains approximately the same.

The chart below graphs index value versus potential gain/loss. Note that a protective put strategy is a combination of long put options and stock.

Protective Put
  VIX Snapshot

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