
Discuss H5: Have portfolio, buy puts within the Financial Management ( FM ) forums, part of the Resolve Your Query  Get Help and discuss Projects category; Have you ever experienced the feeling of owning an equity portfolio, and then, one day, becoming uncomfortable about the overall ...
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H5: Have portfolio, buy puts 
H5: Have portfolio, buy puts 
October 1st, 2010
Have you ever experienced the feeling of owning an equity portfolio, and then, one day, becoming uncomfortable about the overall stock market? Sometimes you may have a view that stock prices will fall in the near future. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy portfolio insurance. Index options is a cheap and easily implementable way of seeking this insurance. The idea is simple. To protect the value of your portfolio from falling below a particular level, buy the right number of put options with the right strike price. When the index falls your portfolio will lose value and the put options bought by you will gain, effectively ensuring that the value of your portfolio does not fall below a particular level. This level depends on the strike price of the options chosen by you. Portfolio insurance using put options is of particular interest to Mutual funds who already own welldiversified portfolios. By buying puts, the fund can limit its downside in case of a market fall. How do we actually do this? We need to know the “beta” of the portfolio. We look at two cases, case one where the portfolio has a beta of 1 and case two where the portfolio beta is not equal to 1. Portfolio insurance when portfolio beta is 1.0 1. Assume we have a welldiversified portfolio with a beta of 1.0, which we would like to insure against a fall in the market. 2. Now we need to choose the strike at which we should buy puts. This is largely a function of how safe we want to play. Assume that the spot Nifty is 1250 and you decide to buy puts with a strike of 1125. This will insure your portfolio against an index fall lower than 1125. 3. When the portfolio beta is one, the number of puts to buy is simply equal to the portfolio value divided by the spot index. Now let us look at the outcome. We have just bought two–month Nifty puts at a strike of 1125. This is designed to ensure that the value of our portfolio does not decline below Rs.0.90 million. (For a portfolio with a beta of 1, a 10% fall in the index directly translates into a 10% fall in the portfolio value). During the two–month period, suppose the Nifty drops to 1080. This is a 13.6% fall in the index. The portfolio value too falls at the same rate and declines to Rs.0.864 million. However the options provide a payoff of (11251080)*4*200 which is equal to Rs.36,000. This is the amount needed to bring the value of the portfolio back to Rs.0.90 million. Portfolio insurance when portfolio beta is not 1.0 1. Assume we have a portfolio with beta equal to 1.2 which we would like to insure against a fall in the market. 2. Now we need to choose the strike at which we should buy puts. This is largely a function of how safe we want to play. Assume that the spot Nifty is 1200 and we decide to buy puts with a strike of 1140. This will insure our portfolio against an index fall lower than 1140. 3. For a portfolio with a nonunit beta, the number of puts to buy equals (portfolio value * portfolio beta)/Index. Assume our portfolio is worth Rs.1 million with a beta of 1.2. Hence the number of puts we need to buy to protect our portfolio from a downside is (10,00,000 *1.2)/1200 which works out to 1000. At a market lot of 200, it means that we will have to buy 5 market lots of two month puts with a strike of 1140. Now let us look at the outcome. We have just bought two month Nifty puts at a strike of 1140. This is designed to ensure the value of our portfolio does not decline below Rs.0.94 million. (For a portfolio with a beta of 1.2, an index fall of 5% translates into a 6% fall in the portfolio value). During the twomonth period, suppose the Nifty drops to 1080. The portfolio value has declined to Rs.0.88 million. (Again, for a portfolio with a beta of 1.2, a 10% fall in the index translates into a 12% fall in the portfolio value). However the options provide a payoff of (11401080)*5*200 which is equal to Rs.60,0000. This is the amount needed to bring the value of the portfolio back to Rs.0.94 million. Advertisements
 
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Re: H5: Have portfolio, buy puts 
Re: H5: Have portfolio, buy puts 
May 8th, 2016
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