Hedging a Portfolio with Puts
An S&P put option gives the buyer the right to participate as the S&P futures market falls below a predetermined strike price until the option expires. The buyer of an S&P put has profit potential in the event of a downturn in the S&P futures market.
Here is an example of how the purchase of a put can be used to hedge a diversified S&P portfolio.
You are concerned that your portfolio which replicates the S&P 500 may erode in value during the near term. You would like to protect the portfolio by purchasing puts, which can offer you leverage. S&P Index puts could be purchased which should rise in value if the index falls, depending on the amount of the index move. Any profit made on the puts could be used to offset a potential loss in the portfolio. Your decision is made with the understanding that there is a possibility that you may lose the entire premium you pay for the options along with commissions and fees associated with the trade. Please be advised that trading futures and options involves substantial risk of loss and is not suitable for all investors. The high degree of leverage that is often attainable in commodity trading can work against you as well as for you. The use of leverage can lead to rapid losses as well as gains.
One full point in the S&P 500 Index has a futures contract value of $250.00. Assume that S&P 500 futures are at 1081. You buy a 1000 S&P put with 66-days until expiration for $3,700. After including a typical commission and fee rate of $50/RT, the total cost to buy the put is $3750. Since one full point in the S&P 500 Index has a value of $250.00, the total cost to buy the put is 15 points. The put strike price is 1000, which is out-of-the-money. You are risking the full $3,750 (15 points) if S&P futures are not below 1000 at expiration. The put breakeven point is an S&P futures level equal to the strike price minus the premium, commissions, and fees. The lower the S&P futures settlement value is below the breakeven point at expiration, the higher your profit. In this example, your breakeven level is 985. This is determined by subtracting the total cost of the trade (15 points) from the 1000 strike price, creating a breakeven level of 985 (1000 -15 = 985).
Outcome 1: Index Level Below Breakeven Level (985)
The potential gain in this scenario is the option strike price minus the current futures price multiplied by the contract size minus the premium, commissions, and fees. An additional commission and fee will be charged to exercise the long put option and then offset the futures position. For example. if S&P futures decline to 950 at expiration, the put will be worth 50 points, or $12,500: [(1000 – 950 = 50) x $250 = $12,500.] Once you determine the value of the put, you subtract the initial total cost of the put ($12,500 – $3,750 = $8,750). Since an additional commission and fee will be charged to exercise the long put option and then offset the futures position, you subtract an additional $50 commissions and fees to determine your profit ($8,750 – $50 = $8,700).
Outcome 2: Index Level Between Strike Price (1000) and Breakeven Level (985)
If, at expiration, S&P futures are between the strike price of 1000 and the breakeven level of 985, you could exercise the put and receive the amount by which the strike price exceeds the index level. The amount received would be less than the original amount paid for the option, but it would offset some of the premium paid. An additional commission and fee will be charged to exercise the long put option and then offset the futures position. For example, if the S&P futures settlement value at expiration is 990, and the put is exercised, you would receive the amount by which the strike price exceeds 990, or a total of $2,500 in this example (1000 – 990 = 10) x $250 = $2,500. Once you determine the value of the put, you subtract the initial total cost of the put ($2,500 – $3,750 = -$1,250). Then, since an additional commission and fee will be charged to exercise the long put option and then offset the futures position, you subtract an additional $50 commissions and fees to determine your profit. Including all the fees and commissions associated with the trade, you would have lost $1,300 from the transaction ($2,500 – $3,700(put) – $100(2Xcommissions and fees) = -$1,300).
Outcome 3: Index Level Above Strike Price (1000)
If S&P futures are at or above 1000 at expiration, you would have lost the entire amount paid to puchase the put, or $3,750 in this example. The premium paid (together with fees and commissions) represents the maximum amount that can be lost by an options buyer.
Again, it is important to remember that if S&P futures decline and/or your opinion changes, the put may be sold at any time up until the last trading day for that particular option series. The option does not have to be held until expiration. The marketplace will determine its value before expiration, which may be substantially more or less than you paid. Profits can be pulled or losses cut at any time during the life of the option. At any time before expiration, a put holder can sell the option to close out the position. This can be done to either realize a profitable gain in the option’s premium or to cut a loss. Most investors holding an in-the-money put option will elect to sell the option in the marketplace if it has value before the end of trading on the option’s last trading day.
Please be advised that trading futures and options involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results.