Protective Put for Index Options

You now know how to hedge a single stock with a protective put. But what if you hold a diversified portfolio? Buying puts on every individual stock is impractical, so instead you hedge with index options, which work differently from equity options in exercise style and settlement.

How Do You Hedge a Portfolio with Index Puts?

• An investor holding a diversified stock portfolio can hedge against broad market declines by purchasing put options on a stock index (e.g., S&P 500 index options, also known as SPX options)
• Index options settle in cash: there is no physical delivery of stocks
• If the index falls, the put gains value, offsetting losses in the portfolio
• Most broad-based index options are European-style (exercisable only at expiration, not before)

Key distinction from equity options: Equity options are American-style (exercise anytime) and physically settled (deliver shares). Broad-based index options are European-style and cash-settled.

How Does Cash Settlement Work for an Index Put?

When an index put is exercised:

• Settlement amount = (Strike price - index settlement value) x the contract multiplier ($100 is the standard convention for most broad-based index options)
• The cash settlement is paid to the put holder on the business day following exercise
• No stock changes hands; only cash

Example: An investor holds a 4,000 put on the S&P 500 index. At expiration, the index settlement value is 3,900.

• Settlement = (4,000 - 3,900) x $100 = $10,000 cash received
• This cash offsets losses in the investor's portfolio caused by the market decline

Think of it this way: With equity options, exercising means shares actually change hands. With index options, there are no shares to deliver (you cannot deliver "the S&P 500"), so the exchange just calculates the difference and sends you a check.

Exam Tip: Gotchas

• Cash settlement occurs the business day AFTER exercise, not on the exercise date itself. This one-day delay is easy to overlook.
• $100 is the standard multiplier for most broad-based index options. If you see a question asking for settlement value, multiply the point difference by $100 unless the question states a different multiplier.

How Do You Calculate the Number of Contracts Needed?

To determine how many index put contracts are needed to hedge a portfolio:

Number of contracts = Portfolio value / (Index level x $100 multiplier)

Example: An investor has a $2,000,000 portfolio. The S&P 500 index is at 4,000.

• Number of contracts = $2,000,000 / (4,000 x $100) = $2,000,000 / $400,000 = 5 contracts

Important limitations:

• This provides an approximate hedge; the correlation between the portfolio and the index affects hedge effectiveness
• Systematic risk (market risk) is what index puts hedge against
• Index puts do NOT protect against company-specific (unsystematic) risk
• If the portfolio is not perfectly correlated with the index (beta not equal to 1), the hedge will be imperfect

Exam Tip: Gotchas

• Index puts hedge systematic risk only, not company-specific risk. If one stock in your portfolio drops due to bad earnings, the index put will not cover that loss.
• The hedge formula uses the index level x $100 multiplier as the denominator. A common wrong answer is dividing by the index level alone (forgetting the $100 multiplier).

How Do Index Options Compare to Equity Options?

Exam Tip: Gotchas

• Index options settle in CASH, not by delivery of the underlying stocks. A scenario may describe an investor exercising an index put and ask what happens next: the answer is cash settlement, not delivery of a basket of stocks.
• Broad-based index options are European-style, so there is no early exercise or early assignment risk.

What Should You Check on Exam Day?

• Can you calculate the cash settlement amount from the strike, the index settlement value, and the $100 multiplier?
• Do you remember settlement is paid the business day AFTER exercise, not on the exercise date itself?
• Can you calculate the number of index put contracts needed from portfolio value, index level, and the multiplier?
• Do you know index puts hedge systematic (market) risk only, not company-specific (unsystematic) risk?