Hedging with Puts

Despite the growing use of options, many potential users have yet to tap these markets and take advantage of the potential benefits they offer. One of the major reasons for that is the frequently expressed perception that options are too difficult and time-consuming to learn. Without a doubt, these markets involve their share of terminology and jargon.

Options on financial futures need not be a difficult topic. The information here may help you to understand how options are used, but understanding how options work is only part of determining whether this kind of investing is right for you.

These instruments may not be suitable for even those who have a full understanding of how they work. Due to the risks, a determination of financial suitability is essential when it comes to options. While the risk for the buyer of an option is limited to the amount paid for the option (along with fees and commissions), for the seller of an option, the risk of loss can be unlimited. Also, for both buyers and sellers, because of the leverage associated with options, small market moves against a position can result in rapid losses.

One place to start to determine if options are right for you is to ask the question: “What can options do for me?”

Short Hedges

One of the most common commercial applications of options on futures is the short hedge,
A put option purchase is used when a bear market is expected. You will realize a profit on the position as long as the option’s intrinsic value at expiration is greater than the amount you paid for it.

Put options are completely separate and distinct from call options. They are similar to calls, though, in setting limits on gains or losses. But since puts provide the buyer with the right to assume a short futures position, the payoff profiles for puts “change direction” as compared to calls. To illustrate, the diagram shows the payout profile of a short futures position.

Compare that with the payout profile for holding a put option.

The put buyer has a bearish market sentiment but has limited risk exposure on the upside. Like the call buyer, he pays the premium up front for the rights granted by the option. In contrast, the person who sold the put option would experience a mirror image payoff profile.

The premium is the most you can lose in a put purchase. You will have to decide which strike price best suits your needs and level of risk tolerance. In-the-money puts cost more but offer better break-even points. If you purchased an out-of-the-money put you would pay less up front, but the market would have to move much further in your favor for you to see a profit. A comparison of put option payoff profiles appears below:

Here is an example of how to use a put option to hedge a declining market.

For the sake of simplicity, we will assume that the option position is held until expiration. Of course, you don’t have to hold your option to expiration. Various factors can cause in-, at-, and out-of-the money options to perform differently before then. If the market has declined, and your option has increased in value to the extent that you want to take your profits, you can always offset it (sell) or exercise it. This may be to your advantage if you are concerned that the market will reverse direction, and you will lose your gains prior to expiration.

Keep in mind, your option can gain value without going into the money. Increasing market volatility, for example, can cause options to gain value. In that case, offset is the obvious choice.

Offset is also advisable in cases where the option is in the money and retains considerable time value. In that case, exercising the option captures only the intrinsic value. Offset captures both.

Exercise is the obvious choice when the option is deep in the money, little or no time value remains, and liquidity factors come into play. Also, because options lose most of their time value in their final month, you may offset early to capture that extra value.

Example Situation: As a portfolio manager heavily invested in long-term notes, you anticipate rising interest rates and declining note prices.

Objective: You want to protect the portfolio’s current market value while retaining the opportunity to profit from a rally.

Strategy: Buy put options on 10-year Treasury note futures.

By purchasing put options, it is possible to establish what amounts to a “floor” for the value of the notes held in your portfolio. The floor level is determined by the strike price of the options you purchase and the commissions and fees associated with the trade. In this case, the higher the strike price, the higher the option premium and floor level. On the other hand, purchasing out-of-the money puts provides less protection at a lower cost.

If interest rates rise and note prices decline, the gain realized from the put option would offset the decrease in the market value of the notes below whatever floor price you have established.

As with any financial management decision, your decision whether to buy put options and the amount of protection needed are judgement calls.

Obviously, the net portfolio return will be reduced by the amount you paid for the options and the commissions and fees associated withth hedge. In the end, your decision to protect the portfolio with puts should be influenced by your market expectations and willingness to incur the risk of a decline in portfolio value.

But keep in mind that the purchase of put options does not preclude profit from an increase in note prices. In this case, your puts would expire, the notes could be sold or held at their higher market value, and the cost of the options could be regarded as the cost of having insurance.

To read more about hedging a portfolio, click here.

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