Buying Index LEAPS Puts To Protect The Value Of A Matched Portfolio

Assume YZX is at 620; therefore, the YZX LEAPS would be valued at 62. If a high quality stock portfolio that closely tracks the YZX is currently valued at $155,000 and the holder is concerned about the market dropping sharply over the next two years, YZX LEAPS puts could be purchased. The purchase of two year YZX LEAPS 60 puts for 3.50 can protect some of the loss in value to a portfolio if YZX dropped below 56.50 (the strike price less the cost of the puts).

To calculate how many YZX LEAPS puts are needed to hedge a stock portfolio, take the current YZX LEAPS value x $100 (the multiplier) and divide that number into the value of the portfolio.

• 62 x $100 = $6,200 (LEAPS value in this case = 1/10 of YZX)

• $155,000/$6,200 = 25 puts.

In other words, to closely hedge a $155,000 portfolio the investor would need to purchase 25 YZX LEAPS puts. In this example, 25 puts with a strike price of 60 will be purchased for 3.50 per contract. We will assume that the YZX drops to 52.70, which is a 15% drop in the value of the YZX during the two year period. The puts would then be about 7.30 points in-the-money.

Original cost: 3.50 x 25 x 100 = ($8,750.00)

Proceeds at expiration of sale/exercise: 7.30 x 25 x 100 = $18,250.00

Total return in this example: = $ 9,500.00

This gain from the puts results in the following comparison of performance of the investor's total portfolio with and without put protection:

Loss in value of unprotected $155,000 portfolio: =($23,250)

Loss in value of protected portfolio: Stock loss: ($23,250)

Gain from YZX LEAPS puts:= 9,500.00

Net loss in this example:=($13,750)

At expiration each two year YZX LEAPS 60 put will be worth $100 for every dollar that YZX falls below the strike price of $60. The cost of purchasing the puts was $8,750.00. If, by expiration, a market decline of 8.9% over the two years has occurred, the puts will be worth the price paid for them. As the market declines below this level, gains in the value of the puts offset losses in the stock portfolio's value. Purchasing a put, therefore, has the effect of putting a floor under the value of the combined stock and option position of the strike price less the cost of the put.

Purchasing YZX LEAPS puts in this example reduces portfolio return by the cost of the puts in exchange for placing a "floor" under the portfolio's value. That "floor" could give an investor concerned about major stock market declines the comfort needed to stay in the stock market and benefit if the market achieves significant gains.

Commissions, dividends, margins, taxes and other transaction charges have not been included. However, they will affect the outcome of option transactions and should be considered. The strategy discussed above is for illustrative and educational purposes only and should not be construed as an endorsement, recommendation or solicitation to buy or sell any particular security.