Question

You work as a trader for an equity fund. On the first trading day of 2008, you are concerned that your long position (1,000 stocks) in a large company in the U.S equity market is subject to significant downside risks for the year, as some potentially negative news could result in market crashes. However, you have no plans to liquidate your long position until the end of 2008.

1. a) Devise a strategy involving taking long positions in options to help protect your stock holdings from potentially negative market movements. You should describe the key attributes of the options you use and justify your choices.

Answer 1

ANSWER DOWN BELOW. FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

During the time when the market crashed is feared then Protective PUT is used as an instrument to hedge the long stock portfolio.

Protective PUT is generally used by portfolio managers to protect their portfolios from sharp declining in the market value of the portfolio.

It is used as a Hedge.

A protective PUT's strike price is generally way below the current market price.

As the stock price is way above its strike price, the put option is out of money.

If the Markets decline sharply then there is a handsome Return from the protective put option, which will help recover the losses occurred in the stock portfolio.