option contracts can provide a portfolio manager with the market
exposure necessary to participate in upside gains at a fraction of the
cost of transacting in the index components.
A cash influx can
pose a strategic dilemma for a portfolio manager. The classic "eat-well/sleep-well"
problems posed by the conflicting desires for both high returns and
investment security apply whenever a manager makes a determination
regarding new or additional investments. By purchasing call options, a
manager can preserve cash in declining markets and retain it for various
purposes, such as meeting redemptions or for investment in lower yield
but essentially "riskless" instruments such as U.S. Treasury
As a simple hypothetical, assume an additional
$900,000 of cash flows into Fund Xs $90 million portfolio. Instead
of simply adding an additional 1 percent to its portfolio of common
stock, the fund manager can purchase SPX call options. With the SPX at a
level of 900, the closest in-the-money call with 30 days until
expiration might be quoted at a premium of 25. The fund purchases 10
call options (900,000/90,000 = 10) for a total cost of $25,000 (10 x 25
The call purchase provides exposure to the broad market
in proportion to the $900,000 influx, limits the downside risk to the
cost of the calls, and the portfolio retains the remaining cash, in the
amount of $875,000.