Protecting a Diversified Portfolio
Example: Investor owns a $300,000 portfolio which closely follows the S&P 500 Index (SPX).
Outlook: Investor has enjoyed a nice run but is worried about a possible market pullback.
Possible strategy: Purchase SPX put options for portfolio protection.
Determine # of SPX Put Contracts Required for Protection
- Portfolio $Value to be Hedged/Notional Value of Index Contract (Strike x $100)
- $300,000/1560 x $100 = 2 SPX puts
- Buy 2 SPX June 1560 Puts @ $41.00 ($4100/Contract)
How the Protection Works
- Assume SPX 1,248 at expiration
- Market is down 20%
- $291,800 stock portfolio now worth $233,440
- 1560 Puts @ $312
- Value of puts: $312 x 2 x 100 = $62,400
- Total Portfolio: $233,440 + 62,400 = 295,840
In Summary: 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.