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 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

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.