Economics Help?
Assume you manage a mutual fund whose prospectus requires it to remain fully invested in U.S. stocks, and you are concerned that stocks generally have become overvalued even though overall sentiment in the market remains bullish. Assume that you wish to limit your exposure to a sharp "correction" in market prices without giving up the possibility of further gains in your portfolio should the bull market continue despite your misgivings.
Describe a risk management strategy that you could implement using an exchange traded derivative product.
Well what about buying put options on my stocks?
That way, if market prices fall below a certain level (more precisely below the strike price of the options), I can exercise the options and sell my shares at the strike price, which is higher than the market price. In this way, in exchange for relatively a small fee, I will effectively have put a limit on how far my selling price can fall.
Should market prices continue to rise, however, I simply will not exercise my put options and keep my (now even more) valuable shares, thus keeping my chance for further gains in my portfolio.