Buying Index Puts to Hedge

Calculating Index Contracts to Hedge a Portfolio

Stock prices tend to move in tandem in response to the overall stock market as measured by the S&P 500 Index (SPX). The 500 stocks that comprise the S&P 500 Index represent almost 85% of the stock market value in the United States. Therefore, the index is an excellent reflection of the overall stock market. If an investor owns a portfolio of stocks and is concerned about a near-term downward move in the overall market, purchasing the appropriate SPX put options could be a desirable alternative to hedging each stock individually.

Determining the number of contracts to use to hedge a portfolio is a fairly simple process using the following formula:

Formula

Each SPX option represents $100 times the strike price. For instance, if an SPX put with a strike price of 1250 is utilized, it would represent $125,000 of market value (1250 x $100). So, an investor with a stock portfolio valued at $500,000 would purchase 4 SPX 1250 puts ($500,000 / $125,000) to hedge the portfolio.

For example, consider an investor who has a diversified stock portfolio valued at $500,000 and is concerned about a market correction of 10% over the next 30 days. With the S&P 500 Index quoted at 1250, a correction of 10% would result in the S&P 500 trading at 1125.00. The investor could choose to purchase four 30-day SPX 1250 puts quoted at 25.00 ($2500 per contract) that would have a total cost of $10,000 or 2% of the value of the portfolio.

SPX	% Gain	Portfolio $ Gain / Loss	Hedging Cost	1250 SPX Put Value	Total	Portfolio % Gain / Loss
1375.00	+10%	$50,000	$10,000	$0	$40,000	+8%
1312.50	+5%	$25,000	$10,000	$0	$15,000	+3%
1250.00	+0%	$0	$10,000	$0	$10,000	-2%
1187.50	-5%	$25,000	$10,000	$25,000	$10,000	-2%
1125.00	-10%	$50,000	$10,000	$50,000	$10,000	-2%

The previous table shows the dollar and percent results of this strategy based on the S&P 500 index at a few levels upon option expiration. Because at-the-money SPX option contracts are used for hedging, the maximum potential loss is equal to the 2% cost of hedging. 2% of performance is sacrificed on the upside if an unanticipated market rally occurs. A payout comparison between a hedged and un-hedged portfolio appears in the payout diagram below.

Payout Diagram

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.