Hedging an S&P 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. This example does not include fees and commissions.

You are concerned that your portfolio or mutual fund 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. The 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.

Assume that S&P futures are at 1185. You buy an 1100 put for $3,000 (12 points), with 51 days until expiration. The put strike price is 1100, which is out of the money. You are risking the full $3,000 if S&P futures are not below 1100 at expiration. The put break-even point is an S&P futures level equal to the strike price minus the premium paid. The lower the S&P futures settlement value is below the break-even point at expiration, the higher your profit. In this example, your break-even level is 1088. This is determined by subtracting the put premium of 12 points from the 1100 strike price, creating a break-even level of 1088.

Possible Outcomes

Outcome 1: Index Level Below Break-Even Level (1088)

If S&P futures decline to 1050 at expiration, the put will be worth 50 points, or $12,500: (1100-1050=50) x $250 = $12,500. Once you determine the value of the put, you subtract the premium paid to determine your profit ($12,500-$3,000= $9,500.)