Strategies
 

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.



Example

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
  
 

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Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (ODD). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606. The information on this website is provided solely for general education and information purposes and therefore should not be considered complete, precise, or current. Many of the matters discussed are subject to detailed rules, regulations, and statutory provisions which should be referred to for additional detail and are subject to changes that may not be reflected in the website information. No statement within the website should be construed as a recommendation to buy or sell a security or to provide investment advice. The inclusion of non-CBOE advertisements on the website should not be construed as an endorsement or an indication of the value of any product, service, or website. The Terms and Conditions govern use of this website and use of this website will be deemed acceptance of those Terms and Conditions.