Chapter 05 · Section 5.1

Setting Limits

In this example, we will assume that you are the manager of a well diversified stock portfolio. The composition of your portfolio reflects the composition of a stock index on which options are traded. We will try to find a way to satisfy two requests:

• You would like to avoid possible losses due to a decrease in the index.
• You would like to profit as much as possible from an increase in the index.

You want to protect your stock portfolio against a decrease in the stock index by setting a limit to the potential loss. You will:

a) buy index calls
b) sell index calls
• c) buy index puts
  Yes. Buying puts limits your loss potential at the expense of a slightly lower profit potential. Continue
  d) sell index puts

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