Chapter 30: Stock Index Hedging Strategies 537 
Example: Suppose that OEX is trading at 364.50 and a September OEX future - if 
one existed would have a fair value of 367.10. That is, the future would command 
a premium of 2.60. Not only should a future trade with that theoretical premium, but 
so should the "synthetic OEX" composed of puts and calls at the same strike. Hence, 
the synthetic OEX constructed with options should trade at about 367.10 also. 
That is, if the OEX Sep 365 call were selling for 4.60 and the Sep 365 put were 
selling for 2.50, then the synthetic OEX constructed by the use of these two options 
would be priced at 367.10. Recall that one determines the synthetic cost by adding 
the strike, 365, to the call price, 4.60, and then subtracting the put price: 365 + 4.60 
2.50 = 367.0. This synthetic price of 367.10 is literally the same as the theoretical 
futures price of 367.10. 
The same calculations can be applied to any index with listed options trading. 
Let us now return to the broader subject at hand - trading market baskets of stocks 
against futures. 
PROGRAM TRADING 
Two terms that conjure up images of the stock market crash in 1987 and other severe 
price drops are "program trading" and "index arbitrage." Neither one by itself should 
affect the stock market, since they are two-sided strategies - involving buying stocks 
and selling futures. This two-sided aspect should have little effect on the market, the­
oretically. However, in practice, it is often the case that trades are not executed simul­
taneously, and the stock market takes a jump or a dive. 
Program trading is nothing more than trading futures against a general stock 
portfolio. Index arbitrage is trading futures against the exact stocks that comprise an 
index. 
Later discussions will assume that one is trying to create or simulate the index 
itself in order to hedge it with futures. This is the arbitrage approach. However, there 
are many other types of stock positions that may be hedged with the futures. These 
might include a portfolio of one's own construction containing various stocks, or 
might include a group of stocks from which one wants to remove "market risk." 
Normally, one would not own the makeup of any index, but rather would have a 
unique combination of stocks in his portfolio. Such an investor may want to use 
futures to hedge what he does own. 
One reason why an investor who owned stocks would want to sell index prod­
ucts against them might be that he has turned bearish and would prefer to sell futures 
rather than incur the costs involved with selling out his stock portfolio (and repur­
chasing it later). Commission charges are quite small on futures transactions as com-