An alternative to selling index futures to hedge a portfolio is to sell index calls while simultaneously buying an equal number of index puts. Doing so will lock in the value of the portfolio to guard against any adverse market movements. This strategy is also known as a protective index collar.
The idea behind the index collar is to finance the purchase of the protective index puts using the premium collected from selling the index calls. However, as a result of selling the index calls, in the event that the fund manager's expectation of a falling market is wrong, his portfolio will not benefit from the rising market.
To hedge a portfolio with index options, we need to first select an index with a high correlation to the portfolio we wish to protect. For instance, if the portfolio consist of mainly technology stocks, the Nasdaq Composite Index might be a good fit and if the portfolio is made up of mainly blue chip companies, then the Dow Jones Industrial Index could be used.
After determining the index to use, we calculate how many put and call contracts to buy and sell to fully hedge the portfolio using the following formula.
No. Index Options Required = Value of Holding / (Index Level x Contract Multiplier)
A fund manager oversees a well diversified portfolio consisting of fifty large cap U.S. stocks with a combined value of $10,000,000 in October. Worried by news about surging oil prices, the fund manager decides to hedge his holding by purchasing slightly out-of-the-money S&P 500 index puts while selling an equal number of slightly out-of-the-money S&P 500 index calls expiring in two months' time. The current level of the S&P 500 is 1500 and the DEC 1475 SPX put contract costs $20 each while the DEC 1525 SPX call contract is quoted at $25 each.
The SPX options has a contract multiplier of $100, and so the number of contracts needed to fully protect his holding is: $10000000/(1500 x $100) = 66.67 or 67 contracts. A total of 67 put options need to be purchased and 67 call options need to be written.
|S&P 500 Index||Call Option Value||Put Option Value||Net Premium Received||Unhedged Portfolio||Hedged Portfolio|
As can be seen from the table above, should the market retreat, as represented by the declining S&P 500 index, the value of the put options rise and almost fully offset the losses taken by the portfolio. Conversely, should the market appreciate, the rise in his holding's value is capped by the rise in the value of the call options sold short. Hence, once the index collar in entered, the fund manager has effectively locked in the value of his portfolio.
Note: The example does not include transaction costs in the calculations and also assumes full correlation (beta of 1.0) between the portfolio and the S&P 500 index.
Your new trading account is immediately funded with $5,000 of virtual money which you can use to test out your trading strategies using OptionHouse's virtual trading platform without risking hard-earned money.
Once you start trading for real, all trades done in the first 60 days will be commission-free up to $1000! This is a limited time offer. Act now!Click here to open a trading account at OptionsHouse.com now!
Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results....[Read on...]
If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount....[Read on...]
Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time.....[Read on...]
If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPSÂ® and why I consider them to be a great option for investing in the next MicrosoftÂ®.... [Read on...]
Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date....[Read on...]
As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative....[Read on...]
Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date....[Read on...]
To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin....[Read on...]
Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading.... [Read on...]
Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator.... [Read on...]
Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa.... [Read on...]
In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as "the greeks".... [Read on...]
Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow.... [Read on...]
Risk Warning: Stocks, futures and binary options trading discussed on this website can be considered High-Risk Trading Operations and their execution can be very risky and may result in significant losses or even in a total loss of all funds on your account. You should not risk more than you afford to lose. Before deciding to trade, you need to ensure that you understand the risks involved taking into account your investment objectives and level of experience. Information on this website is provided strictly for informational and educational purposes only and is not intended as a trading recommendation service. TheOptionsGuide.com shall not be liable for any errors, omissions, or delays in the content, or for any actions taken in reliance thereon.