You now know how to hedge a single stock with a protective put. But what if you hold a diversified portfolio of stocks? You cannot buy puts on every individual stock. Instead, you hedge with index options, and index options work differently from equity options.
Portfolio Hedging 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.
Cash Settlement Mechanics
When an index put is exercised:
- Settlement amount = (Strike price - index settlement value) x $100 multiplier
- 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. The exam may test this one-day delay.
- The multiplier for index options is $100. If you see a question asking for settlement value, multiply the point difference by $100.
Hedge Calculation
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).
Index Options vs. Equity Options
| Feature | Equity Options | Index Options (Broad-Based) |
|---|---|---|
| Exercise style | American (anytime) | European (expiration only) |
| Settlement | Physical delivery of shares | Cash settlement |
| Underlying | 100 shares of one stock | Index value x $100 multiplier |
| Risk hedged | Individual stock risk | Systematic (market) risk |
| Assignment risk | Can be assigned early | No early assignment |
Exam Tip: Gotchas
- Index options settle in CASH, not by delivery of the underlying stocks. The exam may present a scenario where an investor exercises 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.