A trader is concerned about a decline in the U.S. equity markets during the first quarter of 2008 and wants some portfolio protection in the form of S&P 500 Index put options. The put buyer must pay a premium for the put options, if an option is being offered for $50.00, the buyer would pay 100 times the premium, or $5,000.00 per option.
Each put has a unique expiration date and strike price. Today, for example, the S&P 500 is trading near 1,500 and the options have strike prices at 25-point increments of 1,450, 1,475, 1,500, and so on. Furthermore, the options have expiration months ranging from December 2007 to December 2009. What put should he buy?
The strike price is the first consideration. If the S&P 500 is near 1,500, one put option can be purchased to protect a $150,000 stock portfolio (1,500 x $100). The SPX put with a 120 strike price will offer protection if the portfolio declines below $120,000. Puts with lower strike prices have lower premiums and are cheaper but the portfolio will take some losses before the protection kicks in. If the strike prices are far below the value of the index and the premiums are really cheap, it would take a dramatic market decline for them to produce profits enough to offset the losses from the portfolio.
Puts with higher strike prices have higher premiums. The cost of the protection comes at a price: it will lower the return on the portfolio if the market holds steady or moves higher. This is due to time decay, which is an important factor when deciding the best expiration month for the protective put.
Obviously, the best expiration month will depend on the investor’s needs. In this example, the strategist is concerned about the market’s performance during the first quarter. As a result, he might buy the SPX quarterlies that expire in March or June of 2008. Unlike traditional SPX options that expire on the third Friday of the expiration month, quarterlies expire on the last trading day of the calendar quarter.
Importantly, the options with more time left until expiration will cost more than options that have the same strike price and less time left until expiration. In this example, the June options will cost more than the March options and the March options have higher premiums than the December contracts. So, why not buy the December or “front month” options and continually roll the protective position forward?
The risk from buying put options with little time left until expiration comes from the non-linear nature of time decay. Options with little time left until expiration will lose value at a faster rate than options with more time until expiration.
One way to quantify the impact of time decay on a specific option contract is with Theta. It is one of the so-called “Greeks” derived from the Black-Scholes options pricing model. Theta and the other Greeks are available through most brokers or options analysis programs. A Theta of .10 indicates that the option contract will lose 10¢ in value every day.
In the SPX example, the short-term options with a 1,450-strike price, or 50 points below the value of the index, might have a theta near -.25, compared to -.075 for the June options (See “Time is money”). In other words, the front-month contract will lose value at a rate three times greater than the options with six months left until expiration. Therefore, although the cost of the insurance is higher with longer-term options, it will have less of a negative impact on the portfolio’s performance should the market hold steady or move higher.
Finally, the investor also retains the right to close out the protective position at any time prior to expiration. For example, the June 2008 contract can be closed out at the end of March. If the stock market suffers a significant decline during the first quarter, that investor can sell the put at a profit and offset some of the losses in the stock portfolio. So in our example, a March or June 120 put can be closed out at a profit, even if the underlying doesn’t fall at or below that strike. Or, it can be held and then exercised at expiration. If so, the account will be credited with cash equal to the difference between the strike price minus the current value of the S&P 500 (times the multiplier). The hedge comes from the fact that the cash will make up for the losses suffered within the stock portfolio.
Frederic Ruffy is senior writer and trading strategist for Optionetics. He can be reached on his message board a www.optionetics.com.
