Limited Downside Risk with Unlimited Upside Profit Potential
Please note: Commission, dividends, margins, taxes and other transaction charges have not been included in the following examples. However, these costs can have a significant effect on expected returns and should be considered. Because of the importance of tax considerations to all options transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions.
An investor has a portfolio of mixed stocks worth $2 million that closely matches the composition of index XYZ. With the current level of index XYZ at 100, this investor wants to buy XYZ puts to protect the portfolio from a market decline of 4% over the next 60 days. The investor might determine the number of puts to purchase by dividing the amount to be hedged (the $2,000,000 portfolio) by the current aggregate value of index XYZ (100 x 100 multiplier = 10,000). $2,000,000 ÷ 10,000 = 200, so the investor purchases 200 XYZ puts. This number of contracts should be adjusted according to the beta of the portfolio’s performance against XYZ if it does not track the underlying index exactly.
To establish the protective put position with the downside protection needed the investor chooses an XYZ put strike price 4% below the current XYZ level of 100, or the 60-day XYZ 96 put. The XYZ 96 puts are purchased for a quoted price of $0.75, or $75 per option. 200 puts are therefore bought for a total of $75 x 200 contracts = $15,000.
XYZ Index at 100
Buy 200 XYZ 96 Puts at $0.75
Consider three possible scenarios at expiration:
- XYZ closes below 96 put strike price
- XYZ closes between the strike price of 96 and the break-even point
- XYZ closes above the break-even point