Hedging an S&P Portfolio With Puts

Concerned that your portfolio or mutual fund which replicates the S&P 500 may erode in value during the near term? You have options.
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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.)

Outcome 2: Index Level Between Strike Price (1100) and Break-Even Level (1088)

If, at expiration, the S&P futures are between the strike price of 1100 and the break-even level of 1088, 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. For example, if the S&P futures settlement value at expiration is 1092, and the put was exercised, you would receive the amount by which the strike price exceeds this level, or a total of $2,000 in this example (1100-1092=8) x $250=$2,000. You would have lost $1,000 from the transaction ($3,000-$2,000= -$1,000.

Outcome 3: Index Level Above Strike Price (1100)

If S&P futures are at or above 1100 at expiration, you would have lost the entire options premium, or $3,000 in this example. The premium paid 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 through the last trading day of that particular option series. The marketplace will determine its value before expiration, which may be substantially more or less than you paid.

Risk disclosure: past performance is not indicative of future results. The risk of loss in trading futures and options is substantial and such investing is not suitable for all investors. An investor could lose more than the initial investment.

Matt Zeman is a principal with Lasalle Futures Group and chief market strategist for Time Means Money.Com.