Hedging with Stock Options As a stock portfolio manager, you have investments in many U.S. stocks and

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Question:

Hedging with Stock Options As a stock portfolio manager, you have investments in many U.S. stocks and plan to hold these stocks over a long-term period. However, you are concerned that the stock market may experience a temporary decline over the next three months and that your stock portfolio will probably decline by about the same degree as the market. You are aware that options on S&P 500 index futures are available. The following options on S&P 500 index futures are available and have an expiration date about three months from now:

STRIKE PRICE	CALL PREMIUM	PUT PREMIUM
1372	40	24
1428	24	40

The options on S&P 500 index futures are priced at $250 times the quoted premium. Currently, the S&P 500 index level is 1400. The strike price of 1372 represents a 2 percent decline from the prevailing index level, and the strike price of 1428 represents an increase of 2 percent above the prevailing index level.

a. Assume that you want to take an options position to hedge your entire portfolio, which is currently valued at about $700,000. How many index option contracts should you take a position in to hedge your entire portfolio?

b. Assume that you want to create a hedge so that your portfolio will lose no more than 2 percent from its present value. How can you take a position in options on index futures to achieve this goal? What is the cost to you as a result of creating this hedge?

c. Given your expectations of a weak stock market over the next three months, how can you generate some fees from the sale of options on S&P 500 index futures to help cover the cost of purchasing options?