Table: How One Hedge Might Work
Since put options increase in value when stock prices fall, you could protect a diversified stock portfolio from a sudden market decline by purchasing puts in the Standard & Poor's 100 Index, known as "OEX." 1 You determine you'll need five put contracts to protect your $250,000 portfolio by using this formula: Divide the stocks' value by the value of the index* times the underlying number of shares, which is most often 100. The math in this case: $250,000 divided by (529.59 X 100). 2 You only want the protection for the next two months, so you purchase contracts that expire in the middle of October. You buy "at the money" puts at a strike price of 530. They trade at 91/2 points, or $950 per contract, so you need to shell out $4,750 for this "insurance." 3 Should the market suffer a 10% correction, your portfolio would decline by $25,000. The puts, at expiration, would be worth 53.67 points per contract, resulting in a gain of $22,085, or about 88% of your portfolio's losses. If the stock market fell 20%, the puts would recapture 96% of your losses. 4 If the stock market continues its ascent or remains flat, the options expire worthless, and you are out the $4,750 you paid for them. * All prices are as of Aug. 15, 1995 DATA: SWISS AMERICAN SECURITIES INC.
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