Who Should Consider Using Index Puts to Protect a Portfolio?
- An investor who owns a portfolio of mixed stocks and wants to protect its value on the downside.
- An investor whose portfolio tracks exactly, or at a consistent ratio or beta, the performance of an index that underlies a class of index options.
Protective puts are commonly used by equity investors for protection on the downside of the value of underlying shares they own. Index puts may used for the same type of insurance on portfolios of mixed stocks, providing limited loss in case of a market decline. The degree of protection depends on the put strike price selected. As the index goes down, the value of the protective puts can increase, with profits on the options at least partially offsetting any losses seen in the value of the portfolio.
Index puts can be a very useful hedge to protect the value of a portfolio of mixed stocks in case of a market decline. Just as the way protective equity puts work, long index puts can increase in value with a declining underlying index, the degree to which depending on the put strike price chosen. Potential profits on the puts can be realized by either selling the contracts or exercising them if in-the-money, with these gains at least partially offsetting any decline in portfolio value. The puts limit the portfolio loss to a specific level depending on their strike price in relation to the underlying index level when the protective option position is established. On the upside the portfolio’s profit potential is unlimited, but any profits are at least partially reduced by the initial cost of the puts. The break-even point on the upside will be the current portfolio value when it is insured plus the cost of the puts.
Index puts are generally employed to protect unrealized profits from an investor’s portfolio. The index option class chosen should have an underlying index that very closely tracks the performance of the portfolio itself, or at least at a consistent correlation, or beta. There are many option classes available from which puts might be chosen to provide the downside protection a portfolio might need.
American-style index options may be exercised at any time before the contracts expire. European-style index options may be exercised only within a specific period of time, generally on the last business day before expiration. All index options are cash-settled. For contract specifications for various index option classes, please visit the Index Options Product Specification area here.