Are buying puts valid portfolio protection?

Question

Any article you read on buying puts for downside protection always walks through the optimal outcome. It goes like this: You buy cheap puts, the market declines before your puts expire and you have a nice gain on these puts.

In real life, it looks like this: Puts aren't cheap but you buy them anyway. The market doesn't decline enough to make the puts worth anything at expiration. You chewed through the majority of any profits during this time because puts aren't cheap. You very likely ate through some principal as well.

Rinse/repeat and at some point your just portfolio principle begins noticeably eroding. Why - because puts aren't cheap and keep expiring worthless. You'd be better off putting cash under a mattress.

Can anyone explain how this ever works out in real life if the market doesn't decline for a year or two (maybe 9).

Answer 1

OTM protective puts are like a traditional insurance policy. You have a cost and you have a deductible. In the case of puts, the deductible is the underlying's current value less the strike price. The total of the two is your potential loss at expiration.

ATM hedging one year out with SPY puts costs about 6%, more if you use earlier expiries. Hedging individual equity positions will cost even more since equity IV is usually higher. That's a lot of drag on a portfolio. You're going to have to make 6-8% or more on your portfolio just to break even.

How does this work out if the market doesn't decline for a year or two, maybe 9? You know the answer to that. Like all insurance. it's a waste of money until you need it.

If you are willing to sacrifice upside gain, a better alternative for SWAN is to utilize low/no cost collars. You can tailor the R/R to your liking. The higher the reward or the lower the risk, the more the collar costs (and vice versa if you want to shift the R/R ratio in the opposite direction). You play in the middle, collecting your dividends (if any), achieving a decent return in good years and never getting whacked in bad years (see down 50+ pct in 2000 and 2008).

FWIW, another way to look at buying long puts to protect long equity is that it is synthetically equivalent to buying calls (when same series strike and expiration are used). When the underlying moves up, you win. If it stagnates or drops, you lose the cost of the call. Regardless of how you do it, it only works well if it moves nicely in your direction.

Answer 2

Depending on the articles you read, they are either talking about naked puts (where you don't own the underlying stock.index) or protective puts (where you do). They are very different strategies. Naked puts are either speculating about the future direction of the equity (meaning you expect it to go down) or buying "cheap" puts and hoping to get lucky. The latter is not a terrible idea - you buy hundreds of cheap puts, and if one of the equities tank, you collect and make up for the premium lost on the others, but it requires some luck. It's like betting on long shots at the track. You certainly don't expect to win every time, but you hope that a few big payouts make up for all of the losses. You look for a few horses (stocks) that look like good odds relative to what you think their chances are. This generally doesn't work on indices because they are not nearly as prone to catastrophic loss as individual stocks.

Protective puts are more like insurance as Bob illustrates. You give up a relatively small amount (the premium) to protect you against a catastrophic loss. The loss on the equity is countered by the gain on the puts.

Answer 3

Long options are constructed from other financial positions to offer certain characteristics to investors. For instance, long options have a maximum and fixed amount of possible loss.

Compare the long put options to sell-side futures. The Dec E-mini S&P 500 future had a previous close of 2759.25 while the current contract had a previous close of 2744.50. So if the S&P 500 were the same price in December as it is now that could still be a 0.53% gain for holding the December sell-side futures position. Now there is no protection from a market shock except for a stop-loss order but the stop-loss order would not work, for instance, over a weekend. Also the size of the E-mini S&P 500 future is about $137,650 .