The term index put refers to the strategy of buying a put contract to limit the downside risk of a portfolio of stocks. As is the case with protective puts, index puts provide investors with a hedge against a down market, while maintaining unlimited upside potential.
An index put is an investment strategy that involves the purchase of put contracts in an index that closely tracks the performance of a portfolio of stocks in terms of beta. This strategy provides the investor with a hedge against a down market, protecting unrealized profits or limiting a further decline in an unrealized loss. While an index put provides insurance against a bear market, it also provides the investor with upside potential in a bull market.
As a reminder, a put (American) provides the owner with the right, but not an obligation, to sell the index at the strike price at any time before the option's expiration date regardless of how low the stock's price declines. The price paid for the put, is said to be the investor's insurance premium. If the value of the index increases, the investor benefits from the gain in the value of their portfolio and does not exercise their option. If the value of the index declines, the investor has the option of selling the index at the strike price of the in-the-money put to offset the loss in the value of their portfolio.
An investor owns a portfolio of technology stocks worth $500,000 that very closely match the performance of the NASDAQ 100 Index. The current value of the NASDAQ 100 is right around $5,000, so one put option would protect $5,000 x 100 multiplier for the index, or around $500,000 of the portfolio; therefore, only one contract is needed.
The cost of this insurance with a strike price of $4,950 is $35.00, which means the investor would have to pay $35.00 x 100, or $3,500 for this three-month index put. If the price of the NASDAQ 100 increases to $5,100, the value of the investor's profit would be:
= Ending Value of Portfolio - Starting Value of Portfolio - Cost of Index Put
= $510,000 - $500,000 -$3,500, or
= $10,000 - $3,500, or $6,500
If the price of the NASDAQ 100 fell to $4,900, and the investor did not purchase the index put, the investor's loss would be:
= Ending Value of Portfolio - Starting Value of Portfolio
= $490,000 - $500,000, or -$10,000
If the price of the NASDAQ 100 fell to $4,900, and the investor exercised their put at $4,950, the investor's loss would be:
= Ending Value of Portfolio - Starting Value of Portfolio - Cost of Index Put + Profit on Index Put
= $490,000 - $500,000 - $3,500 + $50 x 100, or
= $490,000 - $500,000 - $3,500 + $5,000, or
= -$10,000 -$3,500 + $5,000, or $8,500