Listed Options 101: Buy a put to take advantage of a rise

An investor might be concerned that the current investment climate could become unfavourable for equities in general. He believes he holds a good long-term mix of European equities and instead of selling his portfolio he could temporarily hedge the downside by buying a put option on the Eurostoxx50 index.

If his prediction fails to materialise and his stocks move higher, he will maintain the full upside minus the cost of buying the downside protection through the put option.

In the example we say the investor has a diversified stock portfolio worth EUR 100,000.

This portfolio could be hedged by buying put options on the Eurostoxx50 Index. To avoid paying too high a premium, the investor could choose a strike price that is at the money or slightly out of the money.

With the underlying index at 2260, the premium for a put option with a strike price of 2250 and a 1 month expiry is 64 per contract or 640 Euros given the 10 Euros lot size.

The number of put options to be bought is calculated as follows:

        Portfolio              =     100 000      = 4.44
Strike price X multiplier     2250 X 10

Hedging a perfectly diversified Eurozone portfolio worth 100,000 Euros by buying 5 September put options with a strike price of 2,250 thus costs 3,200 Euros.

Unlike selling futures, buying put options allows the hedger to profit from any rise in the index.

What happens if the price falls?
If the value of the index at expiry is 2034 (-10 pct.), exercising the put options bought 25 days earlier provides a gain of 10,800 Euros ((2250 – 2034) X 5 (number of contracts) X 10 Euros (multiplier)). By using options the investor would have reduced his overall loss on his investment from 10,000 Euros to 2,400 Euros only as the gain on the put minus the initial cost of buying it would be worth 7,600 Euros.

And if the price rises?
If, on the other hand, the index closes at 2,486 (+10 percent), the options are not exercised and the portfolio is worth 110,000 Euros (100,000 Euros + 10 percent) less the premium paid for the options (3,200 Euros).

Source: Bloomberg

As opposed to futures contracts, using options allows an investor to be in a win-win situation. Either the market goes down and the portfolio is hedged, or the market keeps trending and the investor benefits from the full rise minus the premium on the option paid to insure the shares.