Buying Index Puts to Hedge

 

Index XYZ is below 96 put strike price at expiration
 

XYZ Index at 100
Buy 200 XYZ 96 Puts at $0.75

 
Say index XYZ drops 8% and closes below the put strike put strike price of $96 at expiration, at a level of 92. The puts will be in-the-money, and if sold for their total intrinsic value of $400, or exercised for their cash settlement amount of $400 (96 strike price – 92 index level x 100 multiplier), the investor will receive for the 200 puts a total of: $400 put value x 200 contracts = $80,000.

The expected drop in value of the $2 million portfolio, if it in fact closely tracks the performance of index XYZ, would be the 8% decline seen in index XYZ, or $160,000. However, the investor was originally willing to tolerate a decline of 4%, or $80,000, and to insure the portfolio only below that level. With an expected $160,000 loss in portfolio value after this market drop, less the $80,000 received from either selling the puts at expiration or exercising them, the investor has limited the downside loss to 5%, or $80,000, the original goal. This loss could be expected if index XYZ closed at any point below the 96 put strike price at expiration.

But remember, this investor paid $15,000 total premium for the puts in the first place, the cost of insuring the portfolio beyond a 4% decline in value. This cost would be added to a loss in portfolio value, as would any insurance premium paid to protect any asset.

 
 

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